Pan-European clearing house EuroCCP has issued recommendations for reducing the risks of interoperability between central counterparties (CCPs), which advises against sharing collateral between clearers to mitigate exposures from inter-CCP links.
EuroCCP’s position runs counter to conventional wisdom about managing CCP interoperability risks and guidelines in the European Commission’s Code of Conduct on Clearing and Settlement, which is designed to foster greater post-trade connectivity across Europe.
Links between CCPs are deemed important for fostering true competition between trading venues in Europe, as it will ultimately allow venues’ members to choose which clearer to use rather than being forced to use the venue’s incumbent clearer.
EuroCCP’s recommendations are a response to regulatory concerns about CCP links, which have stalled interoperability agreements signed between several of Europe’s main clearing houses, including the UK’s LCH.Clearnet Limited, the Netherlands’ European Multilateral Clearing Facility (EMCF) and Switzerland’s SIX x-clear.
LCH.Clearnet and EMCF, for example, were due to interoperate on 2 November last year, but the deal was postponed as the UK, Dutch and Swiss regulators review the linkage agreements. Chief among regulators’ concerns is inter-CCP risk management.
EuroCCP makes four main recommendations. The first is that each CCP should augment its own existing default fund to cover potential losses if an interoperating CCP fails. Under this arrangement, EuroCCP envisages that each clearer would include the exposure created by any links in the calculation of its default fund and collect any additional margin required from its own participants, retaining the funds in the usual manner.
EuroCCP argues that exchanging margin could create credit, legal and liquidity risk. For example, a CCP may collect little or no margin from a participant but be obliged to pass on a substantial amount of margin to interoperating clearers.
“The recommendation is counter-intuitive but from every angle we think it is superior to exchange of margin which is why we would like the whole community to consider it as the way forward,” Diana Chan, CEO of EuroCCP, told theTRADEnews.com. “Other solutions discussed before concern exchange of margin following the Code of Conduct’s guideline, which says CCPs should have adequate collateralisation amongst themselves,”
One of the problems, according to Chan, is that margin exchange is designed to work in normal market conditions and so may not be sufficient in troubled times, when CCPs are more likely to fail.
“If you have a stressful market, a CCP could get into trouble if, for example, it has a couple of large participant defaults or some liquidity issues. Margin exchange does not cater for these situations and therefore it has systemic risk implications,” she said.
EuroCCP’s second recommendation is an interoperability convention, which the clearer first proposed in June last year, that would replace the current bilateral linkage agreements and foster common risk management approaches among CCPs.
The clearer also recommends removing commercial barriers to interoperability, and giving consideration over the longer term to inter-CCP netting, which would reduce exposures in a similar way to the netting service currently offered by CCPs to members, where a firm’s corresponding buy and sell orders are allowed to cancel each other out.
EuroCCP’s recommendations closely follow an interoperability position paper issued by the Dutch-regulated pan-European clearer EMCF at the end of December, which outlined its proposals for moving forward on CCP links.
In the document EMCF said it envisaged changing its collateral holding structure to allow it to use funds deposited by clients to collateralise links with other CCPs. The clearer’s current legal framework does not allow it to use cash or securities deposited with it for any other purpose than the default of the participant, excluding it from posting collateral with other CCPs.
EMCF also called for harmonisation of CCP legislation in the European Union, and said such legislation should include five key elements: a regulatory framework mandated by law, passport rights for CCP licences throughout Europe, minimum standards of oversight and risk management, a definition of a CCP as an entity that does not take risk positions, and a single public model for interoperability that recognises a CCP as a special market infrastructure.
Pan-European CCP legislation could soon be on the way. In October 2009, the European Commission proposed such a regulation that would impose common safety, regulatory and operational standards for CCPs. The proposals were endorsed on 2 December by the Council of the European Union.