The resilience of central clearinghouses (also known as central counterparties, or CCPs) continues to be an important area of focus in PIMCO’s approach to counterparty management. The advent of mandatory central clearing of over-the-counter (OTC) swap transactions through CCPs in the U.S. and Europe has made the treatment of client collateral, as well as the resolution and recovery framework of CCPs, increasingly important to help ensure the safety of our clients’ assets and the stability of today’s financial markets.
While PIMCO has been generally supportive of the move to the central clearing of derivatives, we remain concerned about the possible unintended, systemic consequences should a CCP fail to manage its risk appropriately or, even worse, fail altogether. Although failure is a low-probability event, PIMCO nevertheless believes that certain global standards should be met by CCPs to maximize the safekeeping of clients’ assets, reduce systemic risk and ensure that the goals of the CCPs are aligned with protecting client assets.
CCPs should be required to have a substantial minimum amount of “skin in the game.”
A major safeguard to help protect against the possible failure of a CCP is its guarantee fund, which provides capital in the event that a client or clearing member firm fails to meet its requirement to post margin. The guarantee fund is made up of 1) initial margin for trades, 2) additional funds from clearing members and the CCP and 3) contingent capital commitments from clearing member firms as well as the CCP. The more capital contributed to the guarantee fund from clearing members, the more incentivized member firms are to ensure that they are managing risk correctly. Similarly, the more contributed capital that the CCP is required to post to the guarantee fund, the more the CCP is inclined to ensure that the margin buffers from clearing members are sufficient and that clearing members’ risk management processes are sufficiently robust.
As currently structured, however, the guarantee fund consists largely of member contributions with little in required direct contributions from the CCP. The contributions the CCP does make are frequently fixed and often based on proprietary models that don’t sufficiently align the incentives of the CCP with its members. Indeed, we worry that without more “skin in the game,” the CCPs will not be sufficiently motivated to protect their own financial interests or the interests of their member firms. Moreover, we do not believe the threat of reputational risk is sufficient incentive for CCPs to align their interests with those of member firms and clients, as some policymakers have asserted.
To make sure that the financial interests of CCPs are properly aligned, PIMCO believes CCPs should be required to adopt (or, at a minimum, CCPs should voluntarily adopt) the following framework:
Minimum contribution from CCPs should be the highest of 5%, US$20 million or the third-largest clearing member contribution. We believe that requiring a minimum contribution from the CCP to the guarantee fund will help to incentivize the CCP to manage its risk appropriately and provide a systemic safeguard should there be simultaneous failures of its clearing members. However, the minimum contribution must be balanced such that it is not so high that it becomes cost-prohibitive for CCPs or so high that it creates a disincentive for clearing members to properly manage their own risk (i.e., not create moral hazard for clearing members). We believe that a contribution floor that is the highest of 5% of the guarantee fund, US$20 million or the size of the third-largest clearing member contribution would be an appropriate amount that would sufficiently increase CCPs’ skin in the game while also balancing business and efficiency concerns.
CCPs’ contributions to the guarantee fund need to be fully funded and not made on a contingent basis . Not only do CCPs need to increase their contributions to the guarantee fund, we believe those contributions need to be fully funded and not funded on a contingent basis (i.e., deposited only if there is a triggering event such as a clearing member default). Generally, capital contributions that are contingent (excluding capital calls) cannot be relied upon during a time of systemic stress as regulators may cause a lock-up of capital, thereby preventing the CCP from following through with its contributions to the guarantee fund.
If a clearing member fails, client assets should only be accessed as a last resort. Additionally, client assets should be afforded the same protections under the futures model as under the cleared OTC model.
In our view, CCP contributions should be accessed before client assets under all circumstances; client assets should be used only in the event of a complete failure of a CCP and never used as a primary resolution and recovery tool for CCPs. Under the current U.S. regulatory framework regarding the protection of collateral for OTC derivatives (“legally separated, operationally commingled,” or LSOC), the collateral of a non-defaulting client cannot be accessed, even in the event of a clearing member default and client default. We support this framework wholeheartedly. Similarly, we would argue that in the event of a CCP default, clients’ assets should only be accessed as a last resort and only after the CCP’s contributions and defaulting members’ contributions have been fully exhausted. If client assets must be used, they should only be used through the pro-rata haircutting of client margin, which should take place on the “total value” of client margin, not only on variation margin, as some have suggested. Using only variation margin goes against the concept of “mutualization” among all members, while total equity is more equitable and defrays the impact on any individual account. Therefore, if there is any haircutting of client margin, it should be on both initial and variation margin across all clients.
We also believe that segregation and protection of client assets for futures transactions should be consistent with cleared OTC swap transactions. Under the regulatory regime in the U.S. governing the collateral for OTC derivatives (LSOC, as noted), collateral of a non-defaulting client is protected in the case of a default of both a clearing member and a client. However, this is not the case for futures transactions: Non-defaulting clients’ collateral posted for futures transactions is not protected and is available to the CCP to mitigate the losses due to a defaulting client. This bifurcation of market standards when it comes to segregation and protection of client assets under the futures and OTC models creates a system that is potentially less safe and more vulnerable to creating uncertainty and additional operational and legal risks for clients, clearing members, CCPs and regulators in the event that a clearing member or CCP were to fail. While certain CCPs might offer portfolio margining of both futures and cleared OTC swap transactions, we believe using this as a solution to resolve any bifurcation of market standards as a result of the different segregation and client asset protection models is sub-optimal.
CCPs should have access to central banks for cash deposits as well as repurchase agreements (repo transactions) for securities.
The inability of a CCP to post cash directly to central banks means in practice that a CCP must invest the cash in a short-term fund or other short-term investments. This increases (not decreases) systemic risk, reduces diversification and, in the event that a CCP default occurs, will require more securities/funds to be liquidated. If a CCP needs to invest cash in third-party investment vehicles, during a period of stress it would be required to liquidate them. At these times, few market participants are able to provide liquidity, and a CCP selling securities would be competing with the rest of the market for scarce liquidity. Using central bank deposits would remove this competition and the interlinkages. In addition, if a CCP could enter into repo transactions of securities in exchange for cash with the central bank as the counterparty, there would be less stress in the market and fewer knock-on effects. A CCP that has the ability to use the central bank in these two ways (at the appropriate haircut) is much less likely to have serial fails or liquidity squeezes that may adversely affect the value of its guarantee funds.
CCPs should perform periodic stress tests.
Standardized stress tests should be performed periodically and consistently by CCPs. While we do not see value in making these stress tests public, we do believe the results should be reviewed and approved by regulators.
Recovery of CCPs is better than resolution of CCPs.
In our view, the recovery of CCPs is a better solution than the resolution of CCPs as recovery allows the markets to continue to function in a more continuous manner. However, the recovery of CCPs should not be guaranteed, just like banks are not guaranteed recovery in the event of a default.
While a possible CCP failure is a very remote event, there is no one single solution that alone will prevent it. However, PIMCO believes that if several conditions are met, including 1) a CCP is capitalized correctly and sufficiently with its own skin in the game, 2) segregation of client assets are consistent across cleared derivatives, 3) CCPs have a way to access cash easily to manage liquidity and 4) stress tests are consistently performed and reviewed, a CCP will be much more likely to recover than to be forced into a resolution process. We believe this is one step in the right direction to help ensure the safety of our clients’ assets and the stability of today’s financial markets.
1Portfolio margining is when margin is calculated based on the remaining liability that remains in the portfolio after all offsetting positions have been netted against each other. Although the protection of client assets for futures versus cleared OTC swap transactions is different, the CFTC regulations do permit futures to be portfolio margined with cleared OTC swap transactions. If this is done, all margin posted in connection with such transactions subject to portfolio margining will be held in the cleared OTC swap transactions collateral account and thus subject to LSOC. This is a sub-optimal approach because this approach does not cover all client positions. It only covers those positions that were portfolio margined with each other.