Resolution and Recovery

By Justin Pugsley

If a central counterparty clearing house (CCP) failed to the extent that derivatives contracts needed tearing up, it is conceivable that the public authorities would have to intervene to contain systemic risk, says one Bank of England deputy governor. 

“The latter stages of a CCP’s recovery plan that terminate in the tearing-up of contracts would probably be ‘orderly’ only in the sense that it would be a prescribed sequence of pre-agreed actions,” Sir Jon Cunliffe, deputy governor, financial stability, at the Bank of England and a member of the Prudential Regulation Committee, told the FIA International Derivatives Expo 2018 in London in June. 

Mr Cunliffe added that a set of circumstances that necessitated terminating derivatives contracts as part of winding down a failing CCP could be a significant “shock” to the system.

Regulatory discretion

He said that under such circumstances he could see a number of reasons why there should be an option for the authorities to step in before a CCP has come to the end of its pre-agreed recovery and wind-down actions.

He believes there are  a number of steps regulators could take to stabilise such a situation.

For example, if there was a serious risk of financial contagion from margin haircutting, the resolution authority could intervene quickly to tear up a subset of contracts earlier than would otherwise be permitted under the rulebook.

“Doing so would return the CCP to a matched book before losses escalated further and before the damage became irreparable,” said Mr Cunliffe, adding that losses from the cancelled positions would still be allocated in the order contractually agreed in the rulebook without discrimination between counterparties.

In a bid to protect financial stability, and while paying regard to legal safeguards, the resolution authority could exercise discretion on the scope and price of the partial tear-up or speed the replenishment of the depleted default fund.

The possible downside of a discretionary approach is that it could create contractural uncertainty and undermine confidence in derivatives contracts among some participants, particularly if termination resulted in them taking larger-than-anticipated losses or smaller profits. 

Information exchange

Nonetheless, Mr Cunliffe said his suggested approach would also allow the resolution authority to better co-ordinate and exchange information with domestic and international peers and market participants in a way that a CCP could not.

”This ability to co-ordinate could be crucial to the orderly management of a systemic event particularly if defaults were impacting multiple CCPs,” said Mr Cunliffe. “An important aspect of stabilising the CCP and the wider market would be to maintain sufficient certainty around the losses that could be incurred in the resolution.”

Meanwhile, clearing member banks presents one of the greatest risks to CCPs should they themselves fail.

As part of building confidence in the UK bank resolution plans, the Bank of England is set to drive greater public transparency around their content. It is hoped that the extra transparency will increase public confidence in the UK’s bank resolution regime.

“So the next phase of work will focus on ensuring that major banks have and are able to demonstrate that they have the systems, documentation, assurance and controls necessary to support their resolvability,” said Mr Cunliffe.

He added that the Bank of England intends to launch a consultation by the end of this year on the details and assurance framework. “We envisage that it will require major UK banks to conduct a self-assessment of their resolvability – measured against the policies and standards that have been established nationally and internationally,” he explained.

He said the Bank of England would then publish its assessment of resolvability for the major UK banks, providing greater transparency over the key judgments of the bank as resolution authority.

The bank would like the first round of self-assessments to take place from 2020, so as to allow the consultation process to fully take place and to reflect changes to firms’ structures required for EU withdrawal and ring-fencing.

“For this reason, the Court of the Bank of England asked the bank’s Independent Evaluation Office to review the bank’s work so far to put in place the UK resolution framework and its plans to make the resolution framework fully operational by the target date of 2022,” Mr Cunliffe explained.

Lesson from Lehman

Mr Cunliffe remains strongly supportive of global efforts to enhance the role of CCPs in the derivatives market. He noted that when Lehman Brothers went bust in September 2008, it had a $35 trillion portfolio of cleared and uncleared derivatives positions, around 5% of the global derivatives market at the time.

The collapse of the US investment bank unleashed $51 trillion in counterparty claims in relation to its uncleared derivatives book. It took four years before the first payouts were made, and some cases are still ongoing.

Mr Cunliffe said the UK Lehman Brothers subsidiary had $9 trillion in cleared interest rate derivatives comprised of 65,000 trades with the UK clearer, LCH. By contrast, it took the clearer just three weeks to hedge out and close these contacts, which was carried out under extreme market conditions. It also used only around a third of the collateral margin Lehman had deposited at the clearing house. He said other CCPs across the world sorted out the failed bank’s cleared derivatives contracts at a similar speed.

Indeed, it is because of this experience that regulators are keen to have as many over-the-counter derivatives contrasts cleared as possible. Derivatives contracts that can’t be cleared, usually due to their bespoke nature, sees them attract higher levels of regulatory capital.

Overall, CCPs greatly simplify the complex web of bilateral relationships, which characterise uncleared derivatives contracts. Nonetheless, giving CCPs such a central role in the global financial system also means that they have to be resilient enough to withstand shocks to maintain market confidence.