An article in the September issue of the Finance newsletter focused on the discussions at the recent G20 meeting in China about what could be done to improve the resilience of central counterparties (CCPs). As the next step in the work being done in this area, the European Commission put forward a proposal on 28 November for legislation to reduce the risks to the financial system if CCPs were to find themselves in distress. 

Growing importance

In 2009 the G20 made a commitment to clear standardised over-the-counter (OTC) derivatives through CCPs. In the EU, this commitment has been implemented under the European Market Infrastructure Regulation, or EMIR, and will increase the scale and systemic importance of CCPs in Europe and beyond. ''That's good for transparency and will reduce risk,'' said Vice-President Valdis Dombrovskis, speaking at the Eurofi Financial Forum 2016 in September. ''But if we are going to rely more on CCPs, we need to have a clear system in place to resolve them if things go wrong.''

The proposed EU Regulation on CCP recovery and resolution should help reduce the risk that any failure of a CCP leads to a knock-on effect, creating wider financial instability, and therefore protect taxpayers from having to bail them out.  Under the proposed new rules, Member States will be required to appoint resolution authorities for CCPs, which will be equipped with common tools and powers that will enable them to intervene if a CCP gets into trouble.

The new legislation reflects the importance of having a single set of rules to manage CCP recovery and resolution. It will clearly assign the roles and responsibilities of every authority involved in the crisis management of a CCP and set up resolution colleges for each CCP in the EU.

Recovery and resolution rules

Under the recovery requirements, CCPs will have to develop detailed plans so that they are better prepared in the case of default or a significant deterioration in their financial situation. These plans, to be approved by the CCP's supervisor, should include measures to recover from several scenarios, including multiple defaults by clearing members and non-default losses such as investment losses, fraud or cyber-attacks. The CCPs themselves will be responsible for the implementation of their recovery plans. In addition, CCP supervisors are granted specific powers to intervene early in the operations of CCPs where their viability is at risk but before they reach the point of failure.  

Under the proposed resolution rules, resolution authorities (public authorities such as central banks) will have several tools at their disposal to deal effectively with the failure of a CCP. Resolution authorities will have to prepare resolution plans for each CCP including which tools to use in which scenarios. For example, the CCP may need to 'tear up' contracts in order to rebalance its financial position or impose 'cash calls' on its clearing members, whereby the non-defaulting clearing members would be asked to replenish the financial resources of the CCP in exchange for an equity stake. Other resolution tools reflect similar provisions in the Bank Recovery and Resolution Directive (BRRD) and include the 'write down and conversion' tool, the 'sale of business' tool and the 'bridge CCP' tool.

Failures of CCPs are very rare - only a handful have failed in recent decades. However, the consequences are potentially very serious as banks and corporates face contagion and have to re-manage their derivatives portfolios in a stressed market. In addition, the inherent cross-border nature of CCPs' activities, their international reach and interconnectedness with other financial institutions, mean that it is vital to have a solid framework in place to intervene when things go wrong.

Read more on derivatives and CCPs; watch the video 'New EU rules for safer Central Counterparties'