“Woefully inadequate” CCPs could pose major systemic risk
Despite the G20 plans put in place since the financial crisis, CCPs are still vulnerable to unforeseen risks and could put the whole financial system in jeopardy in the event of a catastrophic default, according to senior financial services executives speaking in London today.
“The CCP default fund contribution is woefully inadequate,” said Nick Forgan, co-head of global clearing at JP Morgan. “The CCPs only pay 2% towards that fund at the moment, and that contribution needs to increase, because we have to rule out the taxpayer picking up the cost. The industry needs to be able to shoulder this burden, and the ring-fencing of losses is vitally important.”
Speaking on a panel discussion hosted by Deutsche Börse in London, Forgan added that public trust in the system must be protected and the banking industry must be ready to take responsibility. Forgan was supported by fellow panellist Stuart Anderson, vice president of derivatives at Blackrock, who agree that CCPs need to put aside more capital to ensure the safety of the market.
“I agree the regulator has come a long way – and still has a long way to go – but regulation alone can only take us part of the way to a safer future,” he said. “The market needs to do the rest. Most of the pension funds are using derivatives to hedge risk, and they may make a loss due to the costs of variation margin. This is something that definitely needs to be looked at.”
Under the European Commission’s EMIR legislation, the bulk of OTC derivatives contracts now have to be centrally reported to a trade repository, and from 2015 they will also have to be cleared by a CCP. The rule change is intended to protect financial stability by introducing greater transparency and standardisation to complex OTC instruments – but the plans have been dogged by uncertainty about exactly which instruments will be in and out of scope.
“Only five jurisdictions have capital clearing requirements in place,” said David Wright, secretary general at IOSCO. “I expect that number to increase to 15, but we are only 30% of the way to that target right now – and we are already getting pressure in Madrid to delay the requirements. Something like 50% of interest rate swaps and 20% of credit default swaps are currently cleared, so there’s a lot of OTC instruments still out there.”
According to Kay Swinburne, MEP and head of the European Commission’s ECON committee, the regulation on CCP resilience and clearing has come a long way in the last two years. EMIR has set in place a default waterfall, while it is hoped that the clearing obligation will be introduced early next year – although this remains unconfirmed.
“We need to plan for Armageddon, even if it doesn’t happen,” she said. “We can’t allow the market to freeze. But if you ask whether greater interconnectedness between CCPS poses a risk, the answer has to be ‘yes’. The same clearing members will be called upon at the same time for more collateral. Where will they get it from? Perhaps we need to ensure there is a pre-funded recovery fund for the firms that don’t have immediate access to high value liquid assets, in case recapitalisation is needed.”
Regulators and international standards bodies have been looking at ways of shoring up the financial system ever since the crisis. In Europe, there is an increasing emphasis on securitisation – a market that was associated with the crisis of 2007-9, and has never really revived in Europe. The Basel Committee on Banking Supervision and IOSCO have both been exploring the concept of ‘sustainable securitisation’, and the two organisations have been working on models for how the market could be rebuilt, taking into account the lessons of the crash. In the UK, the Bank of England has introduced requirements for CCPs to conduct annual self-assessments, based against standardised stress test criteria. David Bailey, director of financial market infrastructure supervision, warned banks that they would have to justify their choice of CCP to the regulator, “choosing on risk, not only cost”.
“We believe the default waterfall and the incentives should be enough to weather any crisis,” said Olivier Guersent, deputy director general financial stability, financial services and capital markets union at the EU Commission. “However, in an exceptional situation, I don’t think we can find a solution in isolation. There is a moral hazard if we have to resort to public money. I don’t see how one authority could carry that risk alone.”