CCP risk management under regulatory spotlight

Regulators on both sides of the Atlantic have announced measures to tighten supervision of risk management at central counterparties.
By None

Regulators on both sides of the Atlantic have announced measures to tighten supervision of risk management at central counterparties (CCPs).

In the US, the Financial Stability Oversight Council (FSOC), a newly established body responsible for monitoring the country's financial system, has issued a rule that will allow it to designate financial market utilities (FMUs) – which will include CCPs – as systematically important.

Meanwhile the UK's regulator, the Financial Services Authority (FSA), has announced it will consult on proposals to undertake a more “intrusive approach” in supervising existing credit risk management for CCP services.

In the derivatives space, CCPs' risk management processes and calculations affect trading costs by establishing margin requirements and are having to be reassessed in light of regulatory developments. While in equities CCP risk management must be sufficiently robust to supportinteroperability agreements being introduced to facilitate competition in the European market.

Supervisory bodies have scrutinised risk management at CCPs more closely in the last 12-18 months due largely to the growing scale and scope of services they offer and the large number of instruments migrating to central clearing.

Under an agreement made by the Group of 20 countries in September 2009, all standardised OTC derivative contracts must be cleared through CCPs by end-2012. Effected by the European market infrastructure regulation (EMIR) and the Dodd-Frank Act in the US, the migration of OTC derivatives will not only increase the volume of transactions processed by CCPs, it will also increase their number of counterparties and range of products, thereby making the consequences of CCP failure more grave for the wider financial system. In Europe, a regulatory framework is also being laid out to permit brokers to choose between clearing houses rather than accept exchanges' preferred post-trade providers.

FMUs are defined under the Dodd-Frank Act as “any person that manages or operates a multilateral system for the purposes of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions or between financial institutions and the person” This will include major CCPs in addition to other types of utility, according to the FSOC.

For systemically important firms, the Dodd-Frank Act allows US regulators – the board of governors of the Federal Reserve System, the Commodity Futures Trading Commission, and the Securities and Exchange Commission in consultation with the FSOC and other supervisory agencies – to prescribe risk management standards governing operations related to the payment, clearing, and settlement activities of systemically important FMUs. These guidelines will be take into account the relevant international standards and existing prudential requirements.

The designation also subjects the FMU to examinations and reporting requirements, as well as potential enforcement actions. In addition the Fed's board of governors may authorise it to establish and maintain an account of central bank money for a designated FMU.

The FSOC says that it will evaluate any FMU using both data and qualitative reviews on the basis of: the aggregated value of transactions it processes; its exposure to counterparties, other FMUs and payment, clearing or settlement activities; and the effects that its failure would have on the financial system.

The UK's FSA will conduct a rolling review of existing CCP services, in addition to reviews of new applications to offer clearing services and extensions to existing services. These reviews will address: risk management governance and counterparty credit risk control framework; initial margin models; variation margin calculation; default funds; stress testing; wrong way risk and concentration risk; collateral; validation and backtesting.

The FSA is seeking feedback on its assessment of the core components of counterparty credit risk management for CCPs until 10 August 2011.