The World Federation of Exchanges, the global industry group for exchanges and CCPs, has set out how CCPs ensure that certain non-credit losses that might rarely occur in relation to central clearing are allocated in a transparent, predictable and equitable manner.
WFE guidance addresses the treatment of such ‘non-default losses’ (NDLs) as part of its 2019-2020 programme of work on incentives in clearing; and in the context of CCPs’ mission to manage the timely and effective reduction of counterparty credit risk within the financial system.
CCPs work collaboratively with users and supervisors to make derivatives contracts and securities transactions credible and systemically manageable, by minimizing the impact of disruption from user default. As such, clearinghouses are an integral part of exchange-traded financial markets and also support a large proportion of OTC derivatives.
Clearinghouses have supported markets through recent COVID-pandemic volatility, continuing to perform the crucial role recognized by policy-makers after the global crisis of 2008. In doing so, they require market participants to back the risks they take (by posting margin and other resources). For their part, CCPs back their own business offering with capital. This will typically be used to absorb certain non-default losses. But that process remains subject to the practical reality that CCP users may appropriately share liability (for example, this may be the case if they also benefit from any associated rewards), in which case it will be in a manner set out by the clearing house’s rule book.
As the WFE guidance makes clear:
- Not all operational events lead to financial losses.
- Enterprise-risk management and other lines of defence aim at prevention of incidents, whether financially damaging or not.
- Non-default losses remain rare.
- NDLs are of various types, each of which requires distinct analysis.
- The PFMI (written by IOSCO and the CPMI) set out the global standards in relation to NDLs.
- CCPs reserve the right to manage liability in line with industry practice, notably in relation to custodial disruption. (In the case of custody, the third party is itself regulated and the assets may also be ‘bankruptcy remote’ from the service provider’s own balance sheet.)
- No top-10 CCP has in practice ever allocated non-default losses to users.
CCPs, said WFE, are designed to support continuity of positions, profits and hedges, for the benefit of market participants. This makes it important to ensure careful coordination of all interactions with clearing members, with policy on non-default losses that is as clear and forward-looking as possible. While the exact policy for NDLs is a matter for each individual CCP, the current paper sets out what the WFE considers to be some key instances and considerations.
“Non-default losses may not be the main risk faced by CCPs, but it is still important to have a structured approach to dealing with them,” said Nandini Sukumar, Chief Executive Officer of the WFE. “That way, CCPs can devote more time to their day job, ensuring that uncertainty over counterparty credit exposures does not threaten the integrity of the financial system. This is why the WFE has taken the initiative to highlight the responsible, constructive practices employed by clearing houses in relation to potential incidents and their financial consequences if any,” Sukumar added,