How to manage NDLs has long been a topic of discussion among industry bodies, CCPs and market participants. DerivSource explains the concerns surrounding NDLs including how these losses are dealt with at the CCP level and what guidance industry bodies have offered in recent years.
Non-default losses (NDLs) are losses at a central counterparty (CCP) triggered by factors other than the default of a clearing member. NDLs may be the result of investment losses or a consequence of a cyberattack, theft or fraud. These may also derive from failures at a custodian or settlement bank, operational or systems errors, regulatory penalties, legal action taken against the CCP, or from a range of other risk events,
If they are not managed effectively, NDLs can threaten a CCP’s viability and its ability to deliver critical services. Therefore, according to the Principles for Financial Market Infrastructures, published by the Bank for International Settlements’ Committee on Payments and Market Infrastructures (CPMI) and International Organization of Securities Commissions (IOSCO), CCPs must have policies in place to identify, quantify and address NDLs as part of their risk management frameworks.
These risks are distinct from the risk of a clearing member default, which is managed through the provisions of the ‘default waterfall’ – the CCP resource framework through which financial resources are allocated to cover the cost of a defaulting clearing member.
Risk exposure
NDLs fall on a spectrum from low to high severity, ranging from minor losses deriving from small day-to-day incidents, through to major losses from catastrophic events that could threaten a CCP’s viability as a going concern and its ability to provide critical services.
In the event of an NDL, the CPMI-IOSCO Recovery Guidance advises that financial market infrastructure (FMI) entities need to have sufficient liquid net assets, funded by equity, to implement a recovery plan and – in the event that the recovery programme is ineffective – to conduct an orderly wind-down of their critical operations.
Market consultation and guidance
In 2012, CPMI and IOSCO published the Principles for Financial Market Infrastructures (PFMI) with the objective of strengthening international risk management standards for FMIs, including CCPs.
As part of its ongoing review of PFMI, The Committee on Payment and Settlement Systems (CPSS) and IOSCO published a consultation paper (CR05/2022) in August 2022 relating to CCP practices to address NDLs.
Although NDLs are addressed in the PFMI and associated industry guidance, the paper notes that there is still limited understanding of CCPs’ practices to address NDLs.
This contrasts with CCP provisions for addressing the default of a clearing member, where the assessment methodology, available tools (for example, margin models and stress testing) and resources (for example, initial and variation margin, a CCP’s own funds or ‘skin in the game’, and pre-funded default funds) are addressed in detail in the PFMI and are generally well understood by CCP stakeholders.
To address this shortcoming, CPMI and IOSCO issued a questionnaire-based call for evidence, receiving responses from 20 CCPs in 10 jurisdictions. It published its survey findings in a final paper, Report on Current CCP Practices to Address Non-Default Losses, released in August 2023.
Resources and tools
CCPs have a range of resources and tools at their disposal to cover potential NDL. These should operate alongside a proactive set of risk management policies designed to prevent these losses from taking place.
(i) a CCP’s own resources
PFMI Principle 15 calls for CCPs to hold sufficient liquid net assets funded by equity to implement their recovery plans or, if these recovery plans are ineffective, to complete an orderly wind-down. These principles specify that, at minimum, a CCP should hold liquid net assets funded by equity equal to at least six months’ operating expenses. CCPs are required under the PFMI to maintain a viable plan for raising additional equity, should this fall below required levels (CPMI-IOSCO, 2023, p 9).
CPMI and IOSCO warn in their August 2023 paper that some CCPs are relying solely on the minimum amounts stated in the regulatory capital requirements or the six months of current operating expenses specified as the minimum under the PFMI. Relying on these minimum regulatory requirements, without conducting a more detailed analysis of the costs of implementing a recovery and orderly wind-up, may be inconsistent with Principle 15 of the PFMI, the report concludes.
(ii) Rule-based loss allocations
In line with rule-based loss allocations for default losses, some CCPs include provisions in their rulebooks to allocate specific types of NDL to clearing members, most commonly for custody and investment losses. Some CCP rulebooks may also allocate losses to clearing members arising from general business risk, operational risk and legal risk in specified circumstances (see further below).
(iii) External financing
Alongside internal sources of funds to address NDLs, many CCPs have provisions in their risk plans to access external financing. They may draw on committed or uncommitted credit lines, for example, to provide access to short-term liquidity. CCPs may also access additional funds through issuance of bonds and commercial paper, by raising funds through public equity markets, or through other channels.
In their NDL planning, CCPs must recognise that access to liquidity may contract sharply during times of market stress. Consequently, they must have provisions in place to cover any resultant liquidity gaps and timing issues.
(iv) Insurance
CCPs may employ insurance policies to provide coverage for certain types of non-default losses. CPSS and IOSCO note that use of insurance is particularly prevalent for legal and operational risk, although this typically does not cover custody or investment risk (CPSS-IOSCO, 2023, p 10).
The terms of the insurance policy should specify the amount of loss retained by the CCP and the limit of losses covered by the insurer. It is important that CCPs review their insurance policies regularly to ensure that insurance coverage aligns with NDL scenarios addressed in their risk planning. Assuming that a loss event is covered under the policy, there may be a time delay before the insurance claim is paid. Consequently, the CCP may need to supplement insurance coverage with other bridging liquidity arrangements to cover this time gap.
Planning for orderly wind-down
CCPs are required to identify potential NDL scenarios, to calculate their potential exposure and to have strategies in place to address these NDLs on a timely basis.
In preparing for circumstances where the recovery plan may be ineffective, the PFMI require that a CCP prepares plans for its orderly wind down. To do so, a CCP must assess its potential wind-down costs and ensure that it has resources to complete this process – which may include the costs of retaining critical staff, professional fees incurred in the wind-down process, along with potential losses arising through early termination of operating contracts.
Monitoring third-party service providers
In cases where CCPs make use of third-party service providers and liquidity sources, they must conduct regular assessment of potential risks that could trigger, or accentuate, an NDL. Financial regulators may require CCPs to conduct heightened due diligence on third-party providers that deliver critical infrastructure services, for example, that have access to critical CCP data, or that will support the CCP during recovery.
There is no consensus view across the CCP community regarding how NDL should be managed and allocated. The views of CCP management and shareholders may differ significantly from those of clearing members and their clients regarding how NDL should be allocated and the level of resources that CCPs should hold to protect against these potential losses.
Who bears the risk?
In a paper by the Futures Industry Association (FIA) and the International Swaps and Derivatives Association (ISDA) on Non-Default Losses at Clearinghouses, published in July 2020, these trade associations indicate that NDL should be allocated according to “who bears the risk”.
Expanding on this guiding principle, the paper argues that CCPs and their shareholders should bear almost all NDL – particularly for risks that are, according to these associations, exclusively within a CCP’s control, including operational risk, general business risks, legal risk, cyber risk and fraud. However, in some cases clearing members and their clients may bear a portion of NDL relating to custodial risk, settlement bank risk or investment risk (which may include losses resulting from the failure of a repo counterparty, for example, or the default or credit downgrade of a sovereign debt issuer).
The FIA and ISDA indicate that they oppose the use of clearing member cash calls to cover NDLs. Although mutualisation of default losses across clearing members may be justified on the grounds that it encourages clearing member participation in the default management process, the paper concludes that this may increase moral hazard by shielding the CCP’s parent from the consequences of risk management failures at the CCP.
In a position paper published in September 2023, the World Federation of Exchanges (WFE)– an industry group for publicly-regulated trading exchanges and CCPs – emphasises that there is no ‘one-size-fits-all’ solution to CCP resources (WFE, Additional (‘Alternative’) Resources for Recovery, Resolution and Non-Default Loss at CCPs, 2023). International standard setters should not mandate the use of any specific tools, it suggests, given that CCPs require flexibility to serve specific markets in different jurisdictions and with different market structures.
The WFE indicates that it is encouraged by international efforts to strengthen understanding and supervision of CCP risk management. However, an unintended consequence of requiring CCPs to hold greater resources as protection against either default or non-default losses, the WFE suggests, is that this may push market participants away from central clearing.
“The requirement for CCPs to issue debt that they do not need or to keep capital reserves to protect against extreme and unlikely scenarios, including default and non-default loss scenarios, would likely have unintended negative effects on market participation by unnecessarily increasing the costs of central clearing,” the paper concludes (WFE, 2023, p 6-7).
It proposes that these “higher and uncertain” costs are likely to be passed on to end users, which may force users into “riskier” non-centrally cleared bilateral markets, when this is an available option, and may discourage users more generally from hedging their risks.
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