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CCP resilience, recovery and resolution - Resilience of the EU financial sector in the global context

Resources and incentives in CCP resolution

By Gracie Andrew - Executive Director, Resolution, Bank of England

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We should all by now know some of the key benefits of resolution, including delivering continuity of critical economic functions without reliance on support from taxpayers. But another key benefit is incentivising recovery; knowing that a credible and feasible alternative to insolvency (or public bailouts) exists can motivate private sector actions to avert a financial firm’s failure.

CCPs already have recovery mechanisms to deal with the default of one or more clearing members. The well established default management processes, with margin and default funds up to a cover 1 or cover 2 standard, performed well in the last crisis. Beyond these prefunded resources, some CCPs have further loss allocation arrangements, in line with CPMI-IOSCO guidance on recovery.

But these deeper waterfall arrangements are untested. They may not succeed in all circumstances, and can result in undesirable outcomes such as full tear up of contracts in systemic services. That does not sit well with the G20’s support for central clearing of standardised OTC derivatives. You do not want to drown at the bottom of the waterfall. Absent resolution, the fall back is the taxpayer.

For banks, at the point of resolution creditors are bailed in to recapitalise the firm, and this replicates what would have happened in a court-based restructuring or insolvency.

It is vital that the incentives of the key players in CCPs are not misaligned in recovery and resolution.

Applying this to CCPs is not straightforward. Given the deep prefunded and unfunded resources that are potentially available, it begs a question as to what additional loss absorbency the resolution of a CCP could unlock that recovery cannot unlock already. CCPs have different liability structures from banks. Therefore, the assessment of the absorbency of these structures and the appropriateness of additional forms of loss absorbing capacity is more likely to be different from banks than it is to be the same. Attempting to resolve a CCP after the end of the waterfall, when there are no resources left, is not an attractive proposition to a resolver. And for losses other than member default, the resources are far from deep.

This is a key question being addressed by the FSB and other international standard setting bodies under the CCP work plan. I will not prejudge the debate here. But it is vital that the incentives of the key players in CCPs – the owners and the clearing members – are not misaligned in recovery and resolution. Clearing members typically provide the resources for loss allocation arrangements. If losses in resolution then fall on a complete different set of creditors, does that really support recovery?

Equally, clearing members cannot be expected to be a bottomless well of financial support for the CCP, with existing owners left clean and dry forever. Shareholders bear first losses in insolvency and bank resolution. Bailed in creditors typical receive some ownership in the resolved entity. We must consider how to make this work for CCPs as well.