Central Clearing Parties

Regulators around the world have demanded more capital, more collateral and more clearing. And to a large degree they now have what they wanted. …

And yet despite the huge efforts undertaken by market participants there are still two major concerns. The first is that financial regulations from different jurisdictions are not fully aligned with one another. And secondly that the risks in the financial systems have been concentrated into central clearing counterparties (CCPs). These two issues come together in the upcoming regulatory push to devise resolution and recovery regime for CCPs around the world. …

The EU’s push to create a recovery and resolution regime for CCPs … has also created tensions between the clearing houses themselves and their clearing bank and asset manager members, as to who should pay what in the event of a collapse of these critical market infrastructures. …

But, for the EU-institutions, the redline [sic] is that if a CCP fails, then the taxpayer will not be expected to pay.

In whatever way the final text [of the regulation] is balanced, it does not detract from the fact that risk is now heavily focused within these institutions. One of the Euroclear panellists suggested that there is resistance to the ever-increasing march toward central clearing as it is a risk management function, and functions do occasionally fail.

Indeed, just because CCPs have not failed in the past, there is nothing to say that there will not be a CCP crisis in the future. Panellists were concerned that with the small capital base CCPs currently have, any recovery and resolution of a failing CCP will involve direct clearing members standing up to support them through a number of difficult actions for the firms involved. …

One of the key requirements of the draft paper will be a requirement for the CCPs to undertake scenario planning. And for a CCP to fail, it will likely have been triggered by the simultaneous default of two major members. “If a large CCP is in trouble because of its members [sic] default, then we will be having a banking crisis” says Benoît Gourisse, Senior Director, European Public Policy at ISDA.

In November 2020, the Chairs of the FSB, the Committee on Payments and Market Infrastructures (CPMI), the International Organization of Securities Commissions (IOSCO) and of the FSB Resolution Steering Group (ReSG) publicly committed to collaborate on and conduct further work on CCP financial resources in recovery and resolution. Such work would consider the need for, and develop as appropriate, international policy on the use, composition and amount of financial resources in recovery and resolution to further strengthen the resilience and resolvability of CCPs in default and non-default loss scenarios.

Because the scenarios were specific to each CCP, the results cannot be aggregated to simulate total losses at the level of the financial system for any particular scenario. Therefore, system-wide effects were not considered. The analysis did not take into account the underlying economic circumstances that could cause the simultaneous default of four clearing members at each of the seven CCPs, the likelihood of such circumstances, or the potential impact of the same clearing members defaulting in multiple CCPs. Neither did the analysis endeavour to model second and later order effects of the scenarios that might result in wider market stress, including potential increases in margin requirements, liquidity pressure and collateral scarcity. Finally, the analysis assumed that all non-defaulting participants continued to perform as they had committed to.

With three of DTCC’s clearing agency subsidiaries declared as “systemically important financial market utilities” (SIFMUs), Pozmanter [the DTCC Head of Clearing Agency Services and Global Operations] said there has been significant effort and discussions this year to update the clearing corporations’ and the depository’s recovery and wind-down plans. … He asked panelist Stephen Pecchia, DTCC Managing Director, Recovery and Resolution office, about the updated wind-down rules as well as some of the changes to the clearing agency loss allocation rules.

“The Covered Clearing Agency standards require plans for orderly recovery and wind-down,” Pecchia said. “We would seek to wind-down the failed entity and concurrently, shift our services to a third party that has either stood up within the DTCC enterprise or would be some other third-party acquirer. What will happen is essentially a transfer of services: there would be some assignment of assets, there would be service agreements put in place between the failed clearing agencies as well as between the DTCC holding company and this new entity. ” …

“Hopefully this is something we will never have to do, but we do need to be prepared,” he said. “As many of you know, what will drive this potentially happening may not be something we’ve seen historically—but the value comes in the planning. ”

We believe the level of capitalization of a CCP is a key component of its overall resiliency. CCPs must be sufficiently capitalized in order to withstand losses from both member default and non-member default loss events. In response to this, we have implemented a comprehensive capital framework to effectively measure and mitigate risk, and to support the resiliency of DTCC and our subsidiaries.

The Depository Trust & Clearing Corporation (DTCC) is the parent company of various operating subsidiaries, including The Depository Trust Company (DTC), National Securities Clearing Corporation (NSCC), Fixed Income Clearing Corporation (FICC), DTCC ITP LLC (ITP), DTCC Deriv/SERV LLC (Deriv/SERV), DTCC Solutions LLC (Solutions (US)), DTCC Solutions (UK) Limited (Solutions (UK)), Business Entity Data, B.V. (BED); Collectively, the “Company” or “Companies.”

We believe the level of capitalization of a CCP is a key component of its overall resiliency. CCPs must be sufficiently capitalized in order to withstand losses from both member default and non-member default loss events.

Q (E.U.):

Is the investor protected against the insolvency of an intermediary and, if so, how?

A (N.Y. Fed):

… an investor is always vulnerable to a securities intermediary that does not itself have interests in a financial asset sufficient to cover all of the securities entitlements that it has created in that financial asset …

If the secured creditor has “control” over the financial asset it will have priority over entitlement holders …

If the securities intermediary is a clearing corporation, the claims of its creditors have priority over the claims of entitlement holders.

Much of the debate recently has focused on whether CCPs should make larger contributions of their own capital to the loss allocation waterfall as a way to make sure that their risk management is prudent and that they had their own ‘skin in the game.’

An argument could be made that CCPs that are publicly traded may potentially not be aligned with the interests of owners and shareholders, who also used its services.

“We felt it was very important to point out that this argument isn’t applicable to DTCC’s CCPs because in essence the source of our capital is our users,” Pozmanter said. “We don’t feel that putting an outsized portion of that capital at risk as part of our loss allocation waterfall would align our interests any better than they’re already aligned with our owners and users. We look at that as a potential source of instability in a stressed market.”

He added, “While we’re in favor of having some of our capital in the loss waterfall, we think that having a very transparent methodology and a static percentage of our operating capital in the waterfall is what’s most appropriate for us.” …

As for resolution procedures, DTCC is opposed to pre-funding the default loss waterfall, although it does support pre-funding the operating capital needed to get a new CCP up and running in the event of a default.

“As we go through our recovery and resolution planning we want to have the operating capital pre-funded to potentially start up a new CCP in the event of the resolution of one of our CCPs,” Pozmanter said. “We definitely see the logic in having the operating capital to start up a new CCP pre-funded.”

Most large U.S. broker-dealers and banks are full DTC participants, meaning that they deposit and hold securities at DTC. DTC appears in an issuer’s stock records as the sole registered owner of securities deposited at DTC. DTC holds the deposited securities in “fungible bulk,” meaning that there are no specifically identifiable shares directly owned by DTC participants. Rather, each participant owns a pro rata interest in the aggregate number of shares of a particular issuer held at DTC. Correspondingly, each customer of a DTC participant, such as an individual investor, owns a pro rata interest in the shares in which the DTC participant has an interest.