In the context of the continuing industry and regulator discussion regarding central counterparty (CCP) resolvability, last week ISDA published a position paper entitled “CCP Loss Allocation at the End of the Waterfall”. The paper addresses two scenarios:
- “Default Losses” – i.e. losses that remain unallocated once the ‘default waterfall’ is exhausted following a clearing member (“CM”) default; and
- “Non-default Losses” – i.e. losses that do not relate to a CM default but exceed the CCP’s financial resources above the minimum regulatory capital requirements.
ISDA recognises the importance of central clearing for standard OTC derivatives, the difficulty of achieving optimal CCP recovery and resolution and the fact that no loss allocation system can avoid allocating losses to CMs. It takes the view that residual CCP losses should be borne not by the taxpayer, nor solely by surviving CMs who as guarantors have no control over losses. Rather, ISDA believes that all CMs with mark-to-market gains since the onset of the CCP default should share the burden of CCP losses. Accordingly, ISDA is an advocate of Variation Margin Gains Haircutting (“VMGH”) being applied at the end of the default waterfall.
Under a VMGH methodology, the CCP would impose a haircut on cumulative variation margin gains which have accumulated since the day of the CM default. In doing so, ISDA believes that:
- losses fall to those best able to control their loss allocation by flattening or changing their trade positions;
- CMs with gains at risk are incentivised to assist in the default management process; and
- in the event that the CCP runs out of resources, VMGH mimics the economics of insolvency.
ISDA believes that a VMGH methodology should not have an adverse impact on the ability of a CM to net exposures or gain the appropriate regulatory capital treatment for client positions held at the CCP. In contrast to contractual tear-up provisions or forced allocation mechanisms, VMGH allows a CM to assume that its portfolio of cleared transactions outstanding as of any given date will be the same as of the point of a CCP’s insolvency (because there is no mechanism by which they can be extinguished prior to any netting process). As such, because it has certainty with respect to its legal rights in the CCP’s insolvency, the CM should be able to conclude that netting sets remain enforceable. In addition, to the extent that VMGH provides incremental resources to the CCP, ISDA believes that it effectively protects initial margin held at a CCP and therefore strengthens segregation.
In theory, VMGH should always be sufficient to cover a defaulting CM’s mark-to-market losses in the same period. However, if in practice this was not the case (e.g. because the CCP was not able to determine a price for the defaulting CM’s portfolio) and in the absence of other CMs voluntarily assuming positions of the defaulting CM, ISDA advocates a full tear-up of all of the CCP’s contracts in the product line that has exhausted its waterfall resources and has reached 100% haircut of VM gains. ISDA contends that there should be no forced allocation of contracts, invoicing back, partial non-voluntary tear-ups, or any other CCP actions that threaten netting. Furthermore, prior to the point of non-viability, ISDA believes that resolution authorities should not be entitled to interfere with the CCP’s loss allocation provisions (as detailed within its rules) unless not doing so would severely increase systemic risk.
An example of Non-default Loss (“NDL”) would be operational failure. ISDA views NDL in a different light to Default Losses believing there to be no justification for reallocating NDL amongst CMs and other CCP participants. Accordingly, it does not believe that VMGH (or similar end-of-the-waterfall options) are appropriate for allocation of NDL. Rather, it considers that NDL should be borne first by the holders of the CCP’s equity and debt.
The ISDA paper is a useful contribution to the ongoing discussion around CCP resolvability. It suggests a sensible CCP default waterfall, but is probably most noteworthy for its opposition to initial margin (“IM”) haircutting as a resolution tool. In ISDA’s view, IM haircutting would distort segregation and “bankruptcy remoteness”. In doing so it would have significant adverse regulatory capital implications and would create disincentives for general participation in the default management process. In this sense, it adopts the opposite position to that detailed by the Committee on Payment and Settlement Systems (“CPSS”) and the International Organization of Securities Commission (“IOSCO”) in their recent consultative report on the Recovery of financial market infrastructures (see this blog post for more detail). CPSS/IOSCO see IM haircutting as an effective tool which may facilitate access to a much larger pool of assets than VMGH.
There is general agreement on the principle that the taxpayer should never again have to pick up the tab following the failure of a systemically important firm. On this basis alone, one suspects that IM haircutting will ultimately be included in the suite of resolution tools, if only to act as additional buffer between derivatives losses and the public purse. In fairness, it’s difficult to see how a general tear-up of contracts is consistent with one of the underlying goals of CCP resolution – to ensure the continuity of critical services. Ultimately, however, we will have to wait to see whether the contagion which may result from ISDA’s tear-ups outweighs the regulatory impact associated with CPSS/IOSCO’s IM haircutting.
 Pursuant to Article 306(1)(c) of the Capital Requirements Regulation, a CM will likely have to be able to pass on the impact of a CCP default to its clients in order to attract the appropriate regulatory capital treatment