A J.P. Morgan research paper has called for substantive changes to ensure that central counterparties (CCPs) can continue as ongoing concerns and serve as the market-stabilising force envisaged by regulators.
The bank’s Office of Regulatory Affairs has questioned the robustness of CCPs and whether they have sufficient financial safeguards to minimise the threat of the new too big to fail.
It warns against current measures to liquidate CCPs that default, saying the “liquidation of a failed CCP could result in the immediate collapse in the price of many types of collateral typically used for initial margin in cleared, as well as non-cleared, markets”.
It also says end users who expected cash payments would be likely to liquidate assets in order to raise funds—including the same assets that serve as collateral for initial margin. “This would depress the value of these assets and weaken the market, creating a pro-cyclical scenario that could further destabilise a collapsing market.”
J.P. Morgan suggests the current framework is insufficient to address a possible CCP failure. It questions the way resources are sized since CCPs do not share their stress scenarios and associated inputs and methodologies with members or members’ clients. Thus, market participants cannot have full confidence in the sufficiency of the resources.
The current risk mutualisation model also means that the CCP often has little, if any, direct financial stake in the funds used to cover losses from default, notes J.P. Morgan. This can be problematic given their conflicting objectives of market stability versus profit maximisation and could allow for growth at the expense of appropriate rigor in risk management.
J.P. Morgan proposes the following resolution framework and process: the supervisory authority closes the CCP or its holding company; the resolution authority charters and transfers operating subsidiaries to a bridge holding company; the CCP or its holding company is recapitalised by transferring liabilities to the bridge company until the balance sheet reaches appropriate levels The escrowed recapitalisation resources would be used to create a new guarantee fund without requiring initial contributions from CCP members.
It also calls for standardised regulatory stress testing and disclosure should be mandatory to determine the size of required loss absorbing resources. A regulatory driven framework based on sufficiently severe stressed macroeconomic conditions would provide a consistent, initial baseline from which CCPs can start to size their loss absorbing resources, says J.P. Morgan. “CCPs would need to comply with this baseline set of macro assumptions. Remove uncertainty by prefunding all loss-absorbency resources to remove reliance on members’ unfunded commitments or assessments during market instability. Forcing the total liability of all market participants to be fully funded will remove the current uncertainty as to whether funds will be available at the time of greatest need,” it adds.
J.P. Morgan recommends CCPs should have a minimum contribution to the Guarantee Fund. “We recommend that CCPs contribute the greater of 10% of member contributions or the largest single clearing member contribution,” it says.
A disciplined resolution framework, with designated recapitalisation resources funded by CCPs and members, should become the market standard, says J.P. Morgan. “Contributions would be in addition to the guarantee fund and would be held in escrow at a central bank or government agency.
“Only the appropriate government agency would trigger a CCP resolution, at which time the recap fund would be ‘bailed in’ and exchanged for equity in the recapitalised.”
J.P. Morgan also proposes that both the CCP and its members should contribute to the recap fund.