Beyond the Waterfall: Essential Elements of a Clearinghouse Recovery Plan
June 8, 2017By Scott Hill
Auctions, assessments, haircuts and tear-ups can be used to restore a balanced position in case a default overwhelms a clearinghouse's guaranty fund.
As risk management continues to become an increasing priority for global markets, central clearing has emerged as a proven, transparent solution for managing counterparty risk and reducing systemic risk. The central counterparty clearing model has been relied upon in futures markets for more than 100 years, and has a track record of successfully managing all historic instances of financial instability and member defaults.
In general, we agree that a recovery plan must be clear and transparent, and provide sufficient detail for members, end users and regulators to anticipate the likely actions and tools used by a clearinghouse during a member default.
Recognizing the crucial function clearinghouses serve, we have continued to grow our investment in clearing at ICE to develop new technology and risk management practices throughout our global network of clearinghouses across North America, Europe and Asia. We have worked closely with clearing members, end users and regulators to implement clearing models that meet or exceed modern regulatory reforms and international standards.
Each of our clearinghouses has a series of comprehensive controls and protections in place at all times to enable us to respond to an extensive range of extreme but plausible stress scenarios and default events. However, to accommodate the highly unlikely and unprecedented possibility of losses from a default that exceed the defaulting clearing members’ initial margin and the clearinghouse’s guaranty fund resources, ICE clearinghouses also have in place robust recovery plans.
This article outlines the main elements of our recovery plans. In general, we agree that a recovery plan must be clear and transparent, and provide sufficient detail for members, end users and regulators to anticipate the likely actions and tools used by a clearinghouse during a member default. Transparent must not be inappropriately defined as prescriptive such that the clearinghouse is rendered unable to take a set of actions which may successfully manage the unique elements of a given member default.
Key Characteristics Relevant to Recovery Arrangements
Elements of the recovery structure that ICE is developing at each of its global CCPs include:
All clearinghouse defenses support the fundamental principle that the clearinghouse has a balanced position. The layers of protection are designed with the specific purpose of restoring a clearinghouse’s position to balance in the event of clearing member default and preserving the continuity of clearing services.
Position Transfer (Portability)
Non-defaulting, end-user-related positions and, where possible, collateral assets should be transferred (ported) to a non-defaulting clearing member as soon as appropriate from a risk perspective.
Default Auction Participation
Non-defaulting clearing members should be strongly incentivized to participate in default auctions and the use of their guaranty fund contributions could be subordinated (“juniorized”) if they fail to efficiently participate. Non-clearing members may participate in the default auction indirectly as a customer of their clearing member, or customers should be able to participate directly, subject to the consent of their clearing member and, if appropriate, following the contribution of capital to the default waterfall.
Powers of Assessment
Recovery tools such as assessments are not prefunded and we believe that such obligations should be capped in order to provide clearing members with certainty as to the extent of their liability.
Variation margin gains haircutting (sometimes referred to as reduced gains distribution) is a tool of last resort and should only be used on a limited and defined basis to ensure ongoing operation of the clearinghouse.
Partial Tear-Ups and Forced Allocations
Partial tear-ups are preferred to forced allocations because forcing positions on clearing members only may actually increase systemic risk and create contagion effects. Partial tear-ups provide the clearinghouse with the ability to return to a matched book by proportionally decreasing the size of the open positions that were not successfully auctioned and eliminating any current and future risk exposure.