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ISDA® Proposes Clearinghouse Recovery Framework
Practical Law Legal Update 2-597-9506 (Approx. 3 pages)
ISDA® Proposes Clearinghouse Recovery Framework
by Practical Law Finance
| Published on 02 Feb 2015 • USA (National/Federal) |
ISDA has published a position paper setting out a proposed recovery and continuity framework for distressed central counterparties (CCPs), or derivatives clearinghouses, in the event of the failure of a clearing member.
On January 26, 2015, ISDA® published a position paper setting out a proposed recovery and continuity framework for distressed central counterparties (CCPs), or derivatives clearinghouses, in the event of the failure of a clearing member (CM). CCPs are required to develop recovery plans to enable them to recover from a threat to their viability and financial strength and ensure they can maintain continuity of clearing services without requiring the use of resolution powers by authorities or public money.
ISDA published a set of key principles for CCP recovery in November 2014. The framework it has now proposed relates to the restoration of a CCP clearing service whose sustainability has been put at risk due to losses caused by the default of a CM. ISDA has also proposed tools that can be used to re-establish a matched book (under which all of its positions offset for aggregate zero risk) following the default of one or more CMs.
The following elements comprise the proposed framework:
- Recovery measures. The framework provides tools for how a CCP with a large defaulting CM may recover, including:
- a suggested CM-default waterfall which outlines sources of emergency capital in the event of the failure of a CCP CM, in the following order of priority:
- use of the defaulting CM's margin and contributions to the default fund;
- use of the first tranche of the CCP's contributed capital or equity;
- use of mutualized default fund contributions from non-defaulting CMs; and
- limited cash calls.
- loss-allocation measures consisting of a pro-rata reduction in unpaid payment obligations (PRO) of the CCP and an allocation to clearing participants;
- a portfolio auction of the defaulted CM’s portfolio of positions at the CCP; and
- consideration of a partial contract tear-up to assist the CCP in re-establishing a matched book instead of a full contract tear up, provided that all other methods of matching the book have failed and CCP viability is threatened.
- Transparency and timing. Recovery measures should be clearly defined in the CCP’s rulebook to provide transparency and predictability regarding the amount of time the default management process will be allowed to take and the applicable source and utilization of resources.
- Appropriateness of utilizing recovery measures beyond pre-funded resources. This would be based on the CCP's future viability.
- Segregated clearing services. Each type of instrument cleared (for instance, interest rate swaps and credit default swaps) should have its own segregated clearing service, providing for continued clearing operations for unaffected instruments.
- Failure to re-establish a matched book. The failure to do so could result in closure of the clearing service if forced allocation would result in increased systemic risk.
- Clearing participant loss compensation. Clearing participants should be compensated for loss allocation from the CCP, including a pro-rata share in the CCP’s claims against the estate of the defaulting CM and future CCP revenues/profits.
- Resolution. Conditions for CCP entry into resolution and ceasing to provide a clearing service and engaging in a full contract tear-up.
ISDA's proposed framework is based on the assumption that the recovery of a CCP is preferable to its closure. It believes the proposed framework is comprehensive and will be effective in providing:
- The necessary default resources.
- The mechanisms to recover any additional default resources required.
- The allocation of losses.
- If a matching book cannot be recovered, the resolution of the CCP.
The proposed framework is consistent with the instruments and mechanisms contained in the joint report on the recovery of financial market infrastructures (FMIs), published by the International Organization of Securities Commissions (IOSCO) and the Committee on Payments and Market Infrastructure (CPMI) in October 2014 (see Legal Update, BIS/IOSCO Issue Guidance on Clearinghouse Recovery). However, the ISDA proposal only addresses losses caused by CM default, and does not address losses related to liquidity shortfalls or those not caused by a CM default.
"ISDA" is a registered trademark of the International Swaps and Derivatives Association, Inc. (ISDA). ISDA is not a sponsor of Practical Law and had no part in the development of this resource.