Industry discussion over the loss-absorbing capacity of central counterparties (CCPs) has failed to consider the distinction between CCP risk and the risk of clearing members, a white paper from LCH.Clearnet has said.
It warned any increase in the amount CCPs are required to contribute to its default fund, which forms part of the European Market Infrastructure Regulation (EMIR), would change their risk profile and have a serious impact on their resilience at times of market crisis.
The white paper said the existing debate on the ability of CCPs to absorb losses has focused too heavily on CCPs in isolation, rather than considering the role of clearing members and their own recovery and resolution programs.
“The Total Loss-Absorbing Capacity of a CCP is essentially the level of prefunded and contingent resources that are available to the CCP operator to manage a clearing member default,” it wrote.
“The resources – whether prefunded or not – must be provided by the clearing members. The CCP is a mutualised risk structure for the members, and the risk of a default must therefore be borne by the members.”
Under EMIR, CCPs are advised to have some “skin in the game”, meaning they should contribute some of their own funds to the “default waterfall” in order to align interests, with EMIR suggesting 25%. LCH.Clearnet said this an appropriate level to ensure an alignment on interests, but any significant increase could ultimately be dangerous for the stability of the financial system.
The white paper explained, “The purpose of skin in the game is to align the incentives of the CCP operator with those of the clearing members. Any requirement for the CCP operator to contribute significant additional resources to the default waterfall would fundamentally change the operator's risk profile, creating increased risk exposure to member default at the very time that the market needs the operator to be resilient.
“This would also result in the CCP operator becoming an active part of the risk structure, which clearly would be detrimental to financial stability.”
It added that initial margin should remain the first and foremost line of defence against defaults and should be sized such that there will be sufficient prefunded resources available to deal with member defaults.
However, the size of margin is of concern to both the buy- and sell-side, which are already facing much higher costs of trading OTC derivatives due to EMIR and increased margin requirements could potentially reduce liquidity in certain asset classes and reduce the ability of funds to hedge their risk.