CCP resolution, loss allocation and shareholders’ rights

Author:Marc Peters
Position:Solvay Brussels School of Economics and Management, Université Libre de Bruxelles, Brussels, Belgium

Purpose Central clearing counterparties’ (CCPs) specific loss allocation mechanism is reflected in the specific resolution regime designed at the international level. At the same time, international guidance texts require equity to bear losses first in resolution. This creates a tension that immediately exposes resolution authorities to potential claims from CCPs’ shareholders. The... (see full summary)

CCP resolution, loss allocation and
Marc Peters
Solvay Brussels School of Economics and Management,
Université Libre de Bruxelles, Brussels, Belgium
Purpose Central clearing counterparties(CCPs) specic loss allocation mechanism is reected in the
specic resolution regimedesigned at the international level. At the same time, international guidance texts
require equity to bear losses rst in resolution. This creates a tension that immediately exposes resolution
authorities to potentialclaims from CCPsshareholders. The purpose of this paper is to seek possibleoptions
to solve that tension,thereby enabling a workable and credible resolutionregime for CCPs.
Design/methodology/approach The paper analyses the current tension between the no creditor
worse-off (NCWO) counterfactualfor CCPs and the equity bears rst losses in resolutionprinciple. It then
considers six different options to solve this tension, ranging from a revision of insolvency law to the
modicationof the loss-allocation structure.
Findings The paper concludes that additional layers of capital contribution, adapting the contractual
arrangements or articles of incorporation and/or the creation of a specic NCWO counterfactual for
shareholderscould help in solving the identied tension.
Practical implications The paper presentsoptions on how to design a workableand credible resolution
regime for CCPs that would enableresolution authorities to exercise their powers and havethe exibility to
intervene at an early stage in recovery to prevent the exhaustion of available nancial resources, without
being undulyexposed to claims.
Originality/value The paper contributes to the literature on CCP resolution. It is one of the rst to
analyse the articulationbetween the loss-allocation structure of CCPs, the NCWO principle and shareholders
rights. Wehope that this paper will encourage further literatureto develop on this important subject.
Keywords Shareholders, CCP, Resolution, NCWO counterfactual
Paper type Conceptual paper
1. Introduction
Following the 2008 nancial crisis, G20 leaderscommitted to a series of reforms to address
the revealed weaknesses of our nancial system. Two streams of reforms are of particular
relevance in the present context:
(1) The development of resolution regimes for nancial institutions, in particular
systemic banks, that have the objective to ensure the preservation of nancial
stability and the protection of taxpayers.
(2) The requirement to centrally clear over-the-counter (OTC) derivatives markets to
prevent and control the possible contagion of risks across the nancial system.
The case for the recovery and resolution of central clearing counterparties (CCPs) is at the
crossroads of these two streams of initiatives and completes them. Although recent history
Disclaimer: The author reports no conicts of interest. Views expressed in the paper are solely those
of the author.
CCP resolution
Received5 February 2018
Revised6 May 2018
Accepted10 July 2018
Journalof Financial Regulation
Vol.27 No. 2, 2019
pp. 141-159
© Emerald Publishing Limited
DOI 10.1108/JFRC-02-2018-0020
The current issue and full text archive of this journal is available on Emerald Insight at:
has been rather merciful in terms of CCPsfailures, the inherent cross-border and
international nature of their activities, their level of interconnectedness with other nancial
institutions and their growing importance following the G20 commitments on OTC
derivatives make them the critical nodes of the nancial system, the resolution of which
should be carefullyconsidered.
While a naïveapplication of the current resolution regimes for banks is tempting, the
specic business model of CCPs,in particular its approach to loss allocation in the case of a
default by one or more clearing participants, calls for a more cautious and tailor-made
approach (see Section 1.2 on the recoveryand resolution framework for CCPs).
We note that CCPs are subject todifferent risks (e.g. credit, liquidity, operational...)that
could threaten their viability.The underlying causes of these risks can be broadly classied
into two categories: default and non-default events. The Financial Stability Board
[FSB (2017b)]denes the latter as a loss incurred by CCPs for any reason other than the
default of a clearing participant. Examples of non-default events include losses on
investments or because of operational failures or fraud. This type of losses generally does
not entail any mutualised loss allocation mechanisms relying on clearingparticipants. This
means that the loss-absorbing capacity relies entirely on the CCPsshareholders. In this
context, the interplay between resolution actions, shareholdersrights and the NCWO
principle is simplied and similar to the case of banks (see Section 3.1.1 below). Therefore,
the present paper focusses on the resolution of CCPs following the default of one or more
clearing members.
1.1 The role and function of a central clearing counterparty (CCP)[1]
A CCP acts as the buyer to every seller and the seller to every buyer for a specied set of
contracts. Under normal circumstances, a CCP runs a balancedor matchedbook
between its nancial rights and obligations from and towards its clearing members.
However, if one or more clearing members fail to meet their payment obligations, an
unmatched book is created whereby the CCP is left with open directional positions vis-à-vis
its clearing members.
To avoid incurring losses and continue its activities, the CCP must then re-establish a
matched book. This is donevia a default management process based on a contractually pre-
agreed waterfall of nancial resources foreseen in the CCPs operating rules. The waterfall
works with the defaulter paying rst and with the mutualisation of the tail-risk of having
remaining excess losses that willneed to be subsequently shared among clearing members.
Under the European market infrastructure regulation (EMIR)[2], a portion of the capital of
the CCP is also designated to absorb losses before callingon the default fund contributions
of non-defaulting members. This skin in the game[3] (SITG) should align incentives
between the CCP and its clearing members and encourage the CCP to manage its activities
and risks adequately.
To determine the amount of loss that enters the waterfall, the CCP runs an auction
process[4] during which survivingclearing members are offered the possibility to bid for the
positions of the defaulting clearing member(s). This will likely be one of the rst measures
taken in recovery.
If the auctioning process has been unsuccessful or the waterfall is not sufcient, the
CCPs recovery measures would complement existing EMIR provisions, providing
additional recourseto surviving clearing members, notably under the form of:
Partial tear-up: This tool is designed to help the CCP return to a matched book and
crystallise its losses by allowing the CCP to cancel some of its open contracts with
surviving clearing members.

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