Central Clearing Parties

Humpty Dumpty was pushed.
Mr. Potato Head, Toy Story

Central Clearing Parties (CCPs) take on counterparty risk between parties to a transaction and provide clearing and settlement for trades in foreign exchange, securities, options, and most importantly derivative contracts. If a participant fails, the CCP assumes the obligations of the failed clearing participant. The CCP combines the exposures to all clearing members on its balance sheet.

Is there a risk that CCPs might fail?

Euroclear is an International Central Securities Depository (ICSD), which was designed to channel customer collateral to CCPs. In 2020, Euroclear published an article discussing the possibility of failures of CCPs “Regulating the risks of CCPs” [24], in which we find the following remarkable statements of panelists at Euroclear’s Collateral Conference:

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.

The last paragraph is a subterfuge assuring that in the “resolution” the secured creditors will immediately take the underlying assets; that is the plan, i.e., nationalization must not be allowed.

The report goes on:

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 2022, the Financial Stability Board (FSB) and the Committee on Payments and Market Infrastructures at the BIS published the report “Central Counterparty Financial Resources for Recovery and Resolution” [25], in which we find the following statements:

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.

Under the subheading “System-wide and contagion effects and interconnectedness”, the same report states:

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.

Thus, this analysis provided by the “Financial Stability Board” of the BIS absolutely avoided contemplation of exactly what happens in a global financial crisis!

The Depository Trust & Clearing Corporation (DTCC) operates two CCPs, both of which have been designated in the U.S. as Systemically Important Financial Market Utilities (SIFMUs).

The following excerpts are from an article published by DTCC [26] :

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. ”

So, something which has not been seen before will drive the imperative to start up a new CCP, and they are planning for it to happen.

DTCC has provided a video clip titled “Perspectives on CCP Risk Management” [27], in which Murray Pozmanter makes the following statement:

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.

What then is the capitalization of DTCC?

This is an excerpt from the DTCC’s consolidated financial Statements as of March 2023 [28]:

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.”

This is all of DTCC, consolidated, i.e., the whole enchilada.

As of March 31, 2023, the consolidated Total Shareholder’s Equity was a tad over $3.5 billion (that’s with a “b”).

Now realize that this is the entire capitalization underpinning the Central Security Depository and CCPs for the entire U.S. securities market and derivatives complex.

Contrast this with the cited statement:

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.

This is one of the many open deceptions, which are unpleasant and inconvenient to see, and so, readily dismissed. Now recall these excerpts from the exchange between the Legal Certainty Group and lawyers for the Federal Reserve:

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.

So, there we have it. In the collapse of the clearing subsidiaries of DTCC, it is the secured creditors who will take the assets of the entitlement holders. This is where it is going. It is designed to happen suddenly, and on a vast scale.

There are some further relevant statements in the article “DTCC Details Risk Management Approach” [29]:

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.”

There you have it. The CCPs are designed to fail. They are deliberately under-capitalized. The start-up of a new CCP is planned and pre-funded. This construct assures that the secured creditors will take all collateral upon which they will have perfected legal control. The rule of law must prevail! We would have chaos otherwise! No one is above the law, after all!

As a reminder of the structure, here is an excerpt from the Wikipedia article on DTCC [2]:

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.

With the explanation provided by the Federal Reserve Bank of New York (see Chapter 3), you know what this means.