ISDA calls for more CCP ‘skin in the game’

The International Swaps and Derivatives Association has called for increased transparency in the amount of capital central counterparties put aside in the case of a member default.

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The International Swaps and Derivatives Association (ISDA) has called for increased transparency in the amount of capital central counterparties (CCPs) put aside in the case of a member default.

ISDA published a set of key principles on Tuesday on the recovery and resolution tools for CCPs, also known as clearing houses. The swaps association is the latest to criticise the safety of CCPs, as pressures mount for them to increase their skin-in-the-game, the amount of its own financial resources they commit in the event of a member default.

The principles call for increased transparency in the standards and methodologies used by CCPs to size their loss-absorbing resources, such as initial margin, contributions from its members, and its own funds. “Without transparency on CCP risk methodologies, the ability of market participants to accurately assess the adequacy of CCP resources is severely hampered,” ISDA said in a statement.

It states there should be significant CCP skin in the game, as a “CCPs’ contribution to loss-absorbing resources pool should incentivise robust risk management, align CCP management incentives with those of the clearing members, and be fully funded.” 

The release of the principles comes after senior officials at the Bank of England (BoE) and European Central Bank (ECB) called for stress testing of clearing houses and suggested global regulators may introduce minimum capital levels for CCPs, similar to those recently announced for banks.

Speaking at Deutsche Boerse’s “Exchange of Ideas” conference on Monday, David Bailey, director of financial market infrastructure at the BoE, said “The FSB (Financial Stability Board) recently proposed that there must be a minimum level of Total Loss Absorbing Capacity for banks as we need to consider carefully whether and how this concept could be effectively translated to CCPs.”

However, whether these new principles would allow clearing houses to be scenarios of a member default adequately remains to be seen.

“It is very difficult to predict the conditions that would require a recovery plan to be activated. There are many unknowns and uncertainties… So it is not clear if the recovery plan will work as intended,” adds Beniot Coeure, member of the executive board, ECB.

“Some discretion is therefore needed both for the CCPs themselves and perhaps more importantly for the authorities, which cannot take a hands off approach during a crisis situation.”

Clearing houses, which stand between two parties on a trade, have become a crucial part of post-financial crisis regulations. However, with the rise in the volume of cleared trades, regulators and market participants have worried they could be the new focus of systemic risk.

During the Futures Industry Association Expo in Chicago earlier this month some of the world’s largest CCP’s discussed the pressure mounting on them through the skin in the game argument.

Regulators and central banks are urging clearing houses to put up more capital, however the main concern from CCP chiefs is how much to contribute.

“We have to be clear about what it is there for,” said Michael Davie, chief executive officer, LCH.Clearnet. "Primarily it has to drive behaviour, our job in a default is to protect the surviving members and the CCP so it doesn’t go under and do that with a minimum amount of fuss. The quantum of the skin-in-the-game has to be sufficient that the clearers are just doing the right thing.”

With no prescribed amount of ‘skin-in-the-game’ set by regulators, clearing houses are still evaluating how much to contribute themselves.

Peter Hiom, deputy chief executive officer, ASX. noted that the Australian exchange’s contributions account for 65% of its guarantee fund, while CME said it has in excess of USD$350 million.

The panel, which also included the heads of the London Metal Exchange Clearing House and ICE Clear Europe, concurred that ‘skin-in-the-game’ is necessary as an incentive to implement the best risk management systems.

“If you are taking the first loss you have greater incentive to actually make sure you perform default management correctly,” added Cutinho.

“It is all a question of incentives, everything in clearing is structured around incentives.”