The Financial Stability Board is close to finalising a new consultation on financial resources for recovery and resolution at clearing houses, after warning authorities to speed up resolution plans for these growing behemoths.

How to resolve a failing clearing house? This appears to be the million-dollar question that resolution authorities are struggling to answer. Failures at central counterparty clearers (CCP) are remote – only three have failed over the last 55 years and none in the last 36 years – making it difficult for authorities to learn from past crises to inform new policies.

But now that clearing has sky-rocketed since the global move to mandate clearing for much of financial markets, the issue is more pressing. While no CCPs have outright failed, some have come under pressure, such as when Nasdaq had to seize €107m from its members’ default fund to plug a member’s margin gap back in 2018. Five years earlier, a Korean CCP had to raid its mutualised default fund after a member default triggered by a trading error. It cost the surviving members more than $40m.

Therefore, the debate over recovery and resolution plans at CCPs is nothing new, but recent market turbulence has brought it to the fore. The end of loose monetary policy and cheap financing, the rise of red-hot inflation and worsening financial conditions are amplifying regulatory concerns over non-bank financial institutions like CCPs. The likes of the Financial Stability Board (FSB) have once again shone a light on unfinished reforms to resolution planning for central counterparty clearers (CCPs), raising fears they could become a source of systemic weakness.

Resolution: an unfinished agenda

Since clearing houses were promoted after the global financial crisis 15 years ago, they have taken steps to beef up their resilience including committing more resources. However, gaps remain. The resolution piece of the “recovery and resolution” jigsaw is still in limbo in some jurisdictions, with some making more progress than others.

The European Union (EU) is ahead of the pack, say industry experts, having signed off the CCP Recovery and Resolution Regulation, of which the resolution provision started to apply fully in August 2022. Clearing members have welcomed the new regulation, which requires CCPs to put up more of their own capital, aka “skin in the game”, to the tune of 25% of the CCP’s total regulatory capital requirements.

Were a CCP to hit the skids, it would exhaust its capital first before hitting members’ default fund contributions. This has always been the case, but now CCPs in the EU will have to stump up more of their own contributions, in the first instance.

The UK is hot on the heels of the EU. His Majesty’s Treasury introduced legislation to parliament in July 2022 with proposed enhancements to the UK’s CCP resolution regime. Once the legislation is complete, the Bank of England can add statutory tools to its resolution toolbox.

Sarah Willis, a managing associate in the capital markets team at law firm Linklaters, says: “The UK proposal is unlikely to deviate greatly from what has been published in the EU. The UK is on a slower timetable in terms of implementation because the UK is looking into wholesale reform to financial services legislation in general, and is looking at various reforms as to how it regulates CCPs. There are some proposals around setting up a separate regulator for CCPs in the UK.”

Other countries, however, are making slower progress. In Switzerland, the Financial Market Supervisory Authority lacks the power to use CCP-specific resolution tools like variation margin gains haircutting and cash calls. This is set to be addressed as part of a wider revision to Swiss laws commissioned in September last year.

The US is proving to be a mixed bag. While there is no specific law governing resolution of CCPs, as in the EU, there are provisions within the Dodd-Frank Act that would apply in the event of a CCP failure. However, the framework has come under fire from the Federal Deposit Insurance Corporation (FDIC) for being too flimsy, citing a lack of “resolution-specific resources”, “no requirements for US CCPs to file resolution plans” and “no direct ability to require changes to enhance resolvability”.

The FDIC oversees resolution plans for CCPs and their resolution if they ultimately fail, yet does not have oversight over their day-to-day running, which falls to the Commodity Futures Trading Commission. The FDIC’s acting chairman, Martin ‘Marty’ J. Gruenberg, is said to be pursuing progress on CCP resolution as part of his role as chair of the FSB’s resolution steering group.

The FSB is slated to release a consultation later this quarter on potential alternative financial resources and tools for CCP resolution, alongside a comparison to existing resources and tools. This could include novel resources like bail-in bonds, resolution funds, resolution-specific insurance and third-party contractual support, as well as current resources such as resolution cash calls. The outcome of this consultation could lead to changes to existing FSB guidance.

Clearing members are still irked

Clearing members – typically comprising the largest dealers – that are unhappy about the status quo welcome the opportunity to discuss novel ways to address resolution of CCPs. Historically, there has been well-documented tension between clearing houses and their members, who feel that they bear the brunt when things go haywire at a CCP. Some even argue that they should be entitled to a CCP’s equity if it goes into resolution, by way of compensation.

When one of Nasdaq’s clearing house members, Norwegian power trader Einar Aas, was unable to meet his margin requirements in 2018, the clearing house seized €107m from the members’ default fund to plug the gap while contributing just €7m of its own capital. Clearing members described it as a “wake-up” call and forged an alliance to advocate for ways CCPs can boost resilience, recovery and resolution.

However, key members of the alliance feel little progress has been made in the US. They eye developments in the EU, such as the requirement for CCPs to contribute more “skin in the game” under the CCP Recovery and Resolution Regulation, with a degree of envy. One global head of over-the-counter and prime clearing at a Wall Street investment bank tells Global Risk Regulator: “I think there’s been very little progress and frankly, very little engagement from a [US] regulatory perspective. We do think they need to do more.

“More needs to be done from a margin perspective, from an anti-procyclicality perspective and around sizing of default funds and really skin in the game. Broadly, I’d put all of these things under ‘alignment of incentives’. If you see how the industry is consolidating, there has to be better alignment of incentives, certainly from a risk perspective but also from a governance and transparency perspective.”

However, the global head welcomed a recent move from the US Securities and Exchange Commission (SEC) to work on a recovery and resolution proposal. They said: “We think that’s a positive development. Resolution is important. The SEC’s willingness to dig in and focus on resolution planning is certainly an important step.”

Regulators’ list of concerns grows

Cross-border CCPs are playing on regulators’ minds. Resolution planning and resolvability assessments for CCPs that are systemically important in more than one jurisdiction – far from an unusual occurrence – are still in their infancy. Thirteen CCPs are currently identified to be systemically important in more than one jurisdiction. They have all set up crisis management groups (CMGs) and instigated talks for cross-border co-operation, yet none have a full resolution plan in place, warned the FSB in its 2022 Resolution Report.

The FSB identified regulatory gaps. The report says: “While the identification of critical services and functions to be continued in resolution is completed in most CMGs, there is slightly less progress in reviewing the CCP’s own recovery plan and/or wind-down plan and its interaction with resolution planning. One or more preferred resolution strategies for the CCP were identified and discussed in about half of the CMGs. Operational plans to facilitate the effective resolution of the CCP, such as contact lists and information needs and availability, have been considered in about half of the CMGs. Less prevalent are crisis management exercises to test information sharing and coordination procedures.”

The global standard-setter is also analysing other potential left field risks, including non-default loss scenarios such as cyber attacks on clearing houses. Previously, regulators have focused their attention on member default losses such as those seen at Nasdaq in 2018 and in Korea in 2013. However, the growing prominence of CCPs now put them under potential threat from state-sponsored cyber attacks as a way to wreak havoc in financial markets.

Previous analysis published in March 2022 from the FSB, the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions, found that non-default loss scenarios actually generated a larger impact than CCP-specific default loss scenarios. This prompted the FSB to start working on alternative resolution resources.

Colleen Baker, assistant professor of legal studies at Oklahoma University, says: “For many, many years after the financial crisis, there’s been very little focus on non-default losses but they’re incredibly important to figure out who’s going to cover them. The March 2022 [FSB] paper was one of the first times that I recall seeing the authorities looking at different hypothetical scenarios where there are non-default losses and how the CCP holds up.”

Clearing houses argue that, while they can influence resiliency measures and recovery plans, resolution plans ultimately come down to the resolution authorities. Jose Manuel Ortiz-Repiso is head of clearing and repo operations at SIX Securities Services, which operates two of the 13 CCPs classified as systemically important in more than one jurisdiction by the FSB: BME Clearing and SIX x-clear.

SIX Securities Services aims to add more “skin in the game” by mid-February, in line with the new EU rules. Mr Ortiz-Repiso says: “The most valuable thing [we can give] to the clearing members is to try and give them more comfort in that sense….[but] really the resolution plan is the responsibility of the authority – they have to have their plan and assess our resolvability and draw up the resolution.”

Regulatory gaps remain

Regardless of how much CCPs beef up their resilience and authorities try to firm up resolution plans, regulatory gaps persist. The elephant in the room is that there simply are not that many CCPs relative to the amount of risk that flows through them. Concentration risk represents a real problem, stresses Christian Lee, a veteran clearing expert at Sionic. The former head of LCH’s SwapClear Default Management was at the helm of Lehman Brothers’ $90tn portfolio during the financial crisis and helped unwind 66,000 trades.

Mr Lee says: “One of the issues with CCPs compared to banks is that globally, you’ve got [something] like 60 CCPs whereas you’ve got thousands of banks and hundreds of major banks. [In the case of a] bank failure, you could potentially transfer operations over to another bank for continuity of service.

“The problem is that in many jurisdictions, there’s just the one CCP. So effectively that means the resolution authority would need to step in on a temporary basis to run the business. I think that’s one of the reasons why these plans are awfully hard to finalise, because you need to be happy you have a workable, tactical plan.”