The World Federation of Exchanges (WFE), the global industry group for central counterparties (CCPs) and exchanges, has called for a “careful and considered approach” in any change to resolution arrangements at CCPs, as upsetting the tried and tested balance of incentives could damage stability and increase systemic risk.
A core element of central clearing’s value is the predictability of the arrangements to address pre-specified contingencies, together with an incentive structure reinforced by these arrangements’ predictability, the WFE said, in response to the Financial Stability Board’s consultation on the treatment of CCP equity in resolution. Resolution measures should be considered in conjunction with incentives for market participants to participate effectively in any default management and recovery process, said WFE, given that their natural incentive is to walk away from financial liabilities while pursuing claims on others.
The WFE said it welcomes the FSB’s ongoing, and necessary, vigilance around financial stability and insisted that the WFE’s own program of work – to ensure the nature and role of CCP’s is well understood by all stakeholders – is fully aligned with international standard setting authorities in just these goals. Crucially for resolution matters in particular, international standards provide a globally consistent framework but recognize that each clearing arrangement operates within a distinct national legal environment, as well as having its own, unique user base and dynamics.
The other key issue in resolution planning, according to the WFE, concerns realism. While the WFE said it welcomes the FSB’s leadership on this issue, a significant constraint in considering the approach to resolution planning lies in finding a likely extreme scenario that is also plausible. Unfortunately, said the group, the FSB’s draft guidance appears to propose a set of scenarios for adjusting the treatment of CCP equity that is both extreme and implausible.
“The current treatment of CCP equity has been carefully determined, consistent with international standards, to promote incentives for market participants to back the risks they bring to the CCP, and thereby support the stability of the broader financial system,” said Nandini Sukumar, Chief Executive Officer, the WFE.
With respect to the scenario of Custodian and Settlement-Bank Failures, the WFE considers inappropriate that CCP equity should be adjusted to bear all, or even part, of losses from these failures. It is not a CCP’s role to provide a guarantee to the financial industry against custodian and settlement bank losses and providing such a guarantee could undermine a CCP’s role to provide stability to the financial system as a creditworthy intermediary.
With respect to the scenario where a CCP is deemed unable to use its recovery tools, any assumption that CCP equity should be adjusted to bear losses, is inappropriate. In implementing the PFMIs, CCPs are required to operate under a well-founded and enforceable legal framework which includes the use of recovery tools. Therefore, any suggestion that a CCP cannot use its recovery tools effectively implies that the CCP operates in a legal framework that is unenforceable.
With respect to the scenario that CCP shareholders would not support recovery, the WFE maintains that an assumption that CCP equity should be adjusted to bear losses, based on the presumption that a CCP’s shareholders would not support recovery actions, is contrary to the fundamental incentives for shareholders to preserve franchise value.
“An essential part of this consists of incentivizing market participants’ effective participation in the default management and recovery processes. Creating potential rewards in resolution (eg, exposing all CCP equity as a first-loss resource) could undermine the CCP’s resilience or its ability to recover,” Sukumar said.
Click here to read the WFE’s response to the Financial Stability Board consultation in full.