Risk Management in the Field of CCPs

Post Trade Forum – Vienna – 10-11 September 2015

By Giuseppe Insalaco, Markets Policy Division, Market Infrastructure Unit, Central Bank of Ireland

Table of contents

• Are CCPs here to manage risk

or instead to cause it?

• Changing environment: security

vs capital efficiency

• Diversity killed by regulation?

• CCP default scenario: recovery

vs resolution

2

The speaker:

• Senior advisor, Central Bank of Ireland

– Markets Policy Division

– market infrastructure (CCPs, CSDs), trading venues, shadow banking, HFT, virtual currencies, Crowdfunding

• Drafting Level 2 regulation (ESMA PTSC, ESAs TFMI)

• Advisor to Department of Finance re CCP Recovery and Resolution dossier

The Customary Disclaimer

1. This is not investment advice, or regulatory guidance

2. This is not “The BANK”, just me

3. Don’t do as I say, don’t listen to me anyway

Are CCPs the cure or the problem?

• CCPs are designed to solve a

problem, not all problems;

• The technology used by CCPs

has limitations, and (minor)

side-effects;

• As CCPs usage grows, minor

side-effects become large; very

large;

• We are working to mitigate the

side-effects.

3

Horses for Courses The Problem:

• Bilateral counterparty credit risk:

– Trading with “strangers”

– Offsetting/netting across different

counterparties

The Solution:

• Riskless principal creditworthy

middleman

The Technology:

• Poker Rules:

– Settle losses after each round, in cash

– Pre-funding of all bets

4

CCP Risk Management Program:

1) Value all positions

2) Collect all profits in cash

3) If failed collections > 0 then:

A. Identify defaulter

B. Appropriate defaulter “pre-paid losses

fund”

C. Liquidate all defaulter's positions

D. Cover all execution shortfalls using

defaulters “pre-paid losses fund”

E. Terminate defaulter

4) Pay out all losses in cash

5) Goto 1

Are CCPs Effective?

5

-30

-20

-10

0

10

20

30

Pros

Side-effects of Cashification

VM exchanged in

cash

IM is cash-like

instruments

CCP has vast inventory of highly

liquid IM deployable instantly

DCF also highly liquid and quickly

deployable

Cash is the solution….

… but it’s not problem-free

6

Liquidity as proxy for solvency:

– Dependency on liquid markets

and functioning repo facilities

– Problem of reinvestment

– Dependency on collateral quality

– Contagion channel to all asset

classes

Security vs Capital Efficiency

7

Capital to address liquidity:

The CCP risk management is highly

time-sensitive and very rigid (automatic).

• Capital buffers in cash

• CCP skin in the game

• GCM capital guarantee to clients

• Spare capacity (haircuts & add-ons)

• Ban on re-use or re-hypothecation

Cash, in liquid form, is unproductive

capital …

NB: this is a deliberate design feature

(superseniority)

Diversity Killed by Regulation?

8

• CCPs are not islands, they are

nodes in a complex web

• Multi-functionality of Banks:

GCMs, liquidity providers, clients

• Cleared + OTC business + collateral

Same standards, same triggers,

same parameters… clones.

Cost of Creditworthiness: the Waterfall

9

Defaulter Pays Endogenous

mutualisation HIC SUNT LEONES

• The transition point between

phases is arbitrary

• Social trade-off between

regimes (members vs clients)

• The issue of for-profit CCPs

• The cost of “punishing” moral

hazard

EMIR operating zone

CCP Default

10

The Land beyond EMIR:

CCP killers:

• Multiple GCM default

• Loss on investment (collateral downgrade)

• Loss of clients

Where is the money?

• Surviving GCM capital

• Client IM

• Taxpayer

What happens next?

• Recapitalise & keep it going

• Disentangle & distribute bilaterally

• Tear-up

Price of competition is failure: not if…

when.

Cannot build unsinkable ships

Remember: all money is gone

Conclusions

• CCPs are designed to solve a

problem, not all problems;

• The technology used by CCPs

has limitations, and (minor)

side-effects;

• As CCPs usage grows, minor

side effects become large; very

large;

• We are working to fix the

problem

11