ISDA, FIA, IIF Publish CCP Resolution Incentives Analysis

ISDA, FIA and IIF members dispute the appropriateness of extending the NCWOL safeguard to equity holders, and debate the size of the “skin-in-the-game” tranche.

ISDA (the International Swaps and Derivatives Association), FIA (Futures Industry Association) and the IIF (Institute of International Finance) have released a detailed response to the FSB (Financial Stability Board) discussion paper on CCP financial resources to support CCP resolution and the treatment of CCP equity.

The three associations represent firms on both the buy-side and the sell-side. The response represents the views of the associations’ members, but not the views of CCPs, which are noted to disagree with the views. The associations’ first response to the consultation was submitted last month.

The latest response paper reviews the tools and processes around CCP recovery and resolution as well as incentives and disincentives to CCP management, clearing members and their clients. The paper also looks at how these tools may be impacted based on different legal structures of CCPs.

The paper does not cover the impact of tools on the continuity of critical clearing services following resolution, agreeing instead with the FSB that those services can and should be covered by service contracts that include resolution.

Importantly, the associations requested that the FSB re-evaluate the appropriateness of extending the NCWOL (no creditor worse off than in liquidation) safeguard to equity, asking the regulator to lay out its legal basis for the extension.

“The safeguard originated as a means of reducing the likelihood of litigation by creditors challenging a RA’s [resolution authority’s] deviation from the requirement of pari passu treatment of similarly situated creditors, and it is not at all clear why equity holders should be entitled to anything more than the residual value of a remnant CCP, after the payment of all creditor claims (including compensation claims of clearing participants).  At the very least, the FSB should clearly articulate what the legal basis would be for litigation by a CCP’s equity holder, and if it is unable to do so, it should limit the safeguard’s coverage to creditors.”

The members of the three associations, across the buy-side and sell-side, agreed strongly that initial margin haircutting and forced allocation raise significant concerns for market stability.

Members have differing views on VMGH (variation margin gains haircutting), with some believing it should be used only in limited situations due to its pro-cyclicality and destabilising nature. Others believe that a CCP should have flexibility to use it in recovery, subject to regulatory oversight by the CCP’s supervisor.

“Restricting use of the tool in recovery could result in the need for earlier entry into resolution, which they believe would also be destabilising,” the paper notes.

Members also believe that while a resolution cash call can be an additional resource to the resolution authority, incentives among the CCP stakeholders do not align well if this tool is available. Many members also believe that cash calls are unsuitable for CCP recapitalisation – particularly if clearing members were to receive nothing in exchange for their cash.

There continues to be debate between clearing participants and the CCPs on the size of the SITG (“skin-in-the-game”) tranche of the default waterfall. However, the general incentives provided by the SITG to align with interests between the CCP and participants are widely agreed upon.

Members strongly support providing compensation to clearing participants who bear losses in excess of clearing member default fund contributions and capped assessments, and believe that this compensation would provide an equitable solution and incentives for clearing participants to support the default management process, recovery and resolution.

A detailed analysis of each tool can be found here.

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