The uptake of insurance by clearing houses will come down to cost and robustness, Marcus Zickwolff, head of trading and clearing at Eurex Group, says.
About 20 insurance companies have been brought together by New York-based GCSA LLC to offer coverage to clearing houses processing millions of derivatives trades in case of default.
The focus on clearing houses’ ability to withstand a failure has increased following reforms requiring liquid OTC derivatives trades to be cleared through a central counterparty (CCP). The move has raised concerns market risk has now been moved from banks to CCPs.
Zickwolff, who is also the chairman of the European Association of CCP Clearing Houses, told theTRADEnews.com CCP insurance could be one of the tools in a recovery or resolution plan.
“However, I wonder if insurance companies are able to model the probability of clearing house failure and can ensure immediate and unconditional pay-out in such a scenario,” he said.
In the case of clearing member default, CCPs need immediate liquidity, Zickwolff said. “It’s hard to imagine that an insurance company would be immediately and unconditionally able to provide sufficient funding."
He said most CCPs, such as Deutsche Börse-owned Eurex Clearing, have the backing of a mother company that could step in if all lines of defence failed. “Of course, a CCP may find it more attractive to rely on an insurance service – it really depends on the economics and robustness of the insurance offer.”
Education needed
If a member was to go bust, CCPs would first use the margin posted by that counterparty, then use some of its own equity, before diving in to members’ default fund contributions.
Under the proposed insurance solution, when all default funds were exhausted, the GSCA and its group of insurers would then step in.
Christopher Cononico, founder of GCSA, said insurance brings diversification and has been used in a default waterfall before.
“We’ve tried to be innovative in coming up with twists on traditional insurance to make sure it’s customised for clearing.”
He said insurance companies within the group were the primary risk takers and there would be no “endless chain of re-insurance”.
Addressing Zickwolff’s concern about immediate access to funds, Cononico said the role of insurance companies was to absorb losses, but the group could work with CCPs to get money fast.
CCPs with unsecured liquidity facilities could provide liquidity
immediately and the insurance companies would then pay those back, he said.
“Another idea was having collateral insurance, which is something that the insurance group could post to a committed secured credit facility to assist a clearing house in getting immediate access to funds.”
Cononico said there has been a lot of enthusiasm from CCPs, but GCSA was still working on explaining how the process would work.
“Right now, we’re focused on making sure we work closely with all the stakeholders and put something out there that works for each client independently.”
Recent history
There have
been three examples of CCP failures in the past 40 years.
French CCP Caisse de Liquidation went down in 1974, as result of clearing
members defaulting on margin calls due to a free fall in the price of sugar
futures.
In 1983, the Kuala Lumpur Commodities Clearing House failed when palm oil futures prices caused a number of large broker members to default. And four years later, Black Monday led to the failure of the Hong Kong Futures Exchange clearing house, sparking a bailout of its holding company by the government and a number of large financial institutions.
Virginie O’Shea, senior analyst at Aite and author of a recent report on OTC derivatives clearing said the incidents explain why regulators are so focused on default fund contributions, particularly following the arrival of OTC derivatives clearing.
“There has been a lot of communication on default funds and whether they are big enough,” she said.
The Committee on Payment and Settlement Systems and the International Organization of Securities Commission released 24 principles for systematically important market infrastructures, including CCPs, in 2012, addressing clearing houses increased importance in the market and the need for default procedures.
The Bank of England, which assumed responsibility for regulating local CCPs and securities settlement systems in April 2013, has also been closely monitoring clearing houses.
Last week, the central bank released an update report that found all UK CCPs have now introduced arrangements to manage clearing member default losses that exceed their pre-funded resources.
“There is some pressure on central banks to step in and prevent a crisis,” O’Shea said. “And questions remain on whether the insurance route is going to be robust enough. Insurers are not exposed to the derivatives market, so there is one degree of assurance.”
O’Shea said uptake of CCP insurance would come down to price or pressure from regulators and members.
“How will they get the money to put aside for insurance? I’m not sure. It’s another thing to add on top of a list of things they’re asked to hold capital for. CCPs want to be seen publicly as taking precautions, but the costs could add up and put them out of business,” she said.