MEMORANDUM TO: File No. S7-03-14 FROM: Paul A. Gumagay Office of Commissioner Luis A. Aguilar DATE: January 7, 2015 SUBJECT: Meeting with Representatives of LCH.Clearnet Group On January 7, 2015, Paul A. Gumagay, Counsel to Commissioner Aguilar, and Neil Lombardo, Counsel to Commissioner Aguilar, met with the LCH.Clearnet Group representatives Suneel Bakhshi (Group Chief Executive), Michael Davie (Chief Executive, LCH.Clearnet Ltd.), David Weisbrod (CEO), Susan Milligan (U.S. Public Policy Head), and Peter Rich (Rich Feuer Group). The discussion included, among other things, the Commission’s proposed rules regarding the Standards for Covered Clearing Agencies. The LCH.Clearnet Group representatives also provided the attached document. CCP RISK MANAGEMENT, RECOVERY & RESOLUTION An LCH.Clearnet White Paper Table of Contents Executive Summary 3 1. Risk Management 5 2. Recovery Tools 6 3. Resolution Plans 6 Conclusion 7 Introduction 8 Chapter 1: A Resilient Risk Management Framework 10 1.1 Default management framework 11 Strict Membership Requirements 11 Independent Risk Committees 11 Margin Beyond the Regulatory Minimum 11 Auction Incentives 12 Skin in the Game 12 Mutualised Default Fund 13 1.2 Policy Issues 13 Transparency 14 Stress Testing 15 Skin in the Game (SIG) 16 Chapter 2: CCP Recovery Tools 17 2.1 Recovery Tools for Default Losses That 17 Exceed Pre-funded Resources 2.2 Recovery Tools For Non-default Losses 20 Capital and Recapitalisation 20 Insurance 21 Other Tools: Loss Allocation and Cash Calls 21 2.3 Policy Issues 22 Impact of VMGH 22 Compensation 22 Depository Risk 22 Total Loss Absorbing Capacity (TLAC) 23 Chapter 3: CCP Resolution: Providing Continuity Of Service 24 Lead Resolution Authority 24 Cross-border Coordination 25 Resolution Powers 25 Resolution Should Not Give Rise to Open-ended Liability 26 Pre-funded Resolution Funds 26 Conclusion 27 EXECUTIVE SUMMARY • T he core purpose of central clearing counterparties (CCPs) is the management and mitigation of risk. By acting as the buyer to every seller and the seller to every buyer, CCPs reduce counterparty risk, absorb shocks and help to prevent the buildup of excessive risk in the financial system. In addition, CCPs bring efficiencies to market participants by reducing counterparty exposure through the multilateral netting of positions and, in some cases, offering services such as portfolio compression. • L CH.Clearnet Group (LCH.Clearnet) is the world’s leading CCP. We operate CCPs in the United States, UK and France , serving 275 customers in more than 20 countries across a range of asset classes, including equities, fixed income, derivatives, commodities and foreign exchange (FX). As we have expanded our clearing services, we have taken major steps to strengthen the protections we provide to our customers and the financial markets more broadly. Simply, our mission is to be the most trusted CCP in the markets we serve. • T his paper explains LCH.Clearnet’s approach to three areas: risk management, recovery and resolution. Recent debate on these issues has focused on a CCP’s total loss-absorbing capacity and the size of a CCP’s own resources. In our view, this debate has not been clear as to the distinction between clearing members’ resources and those of the CCP operator. The risks to which CCP members are exposed are different than those of the CCP operator. A CCP is essentially a risk management system through which clearing members can mutualize their counterparty risk and benefit from other services; e.g., portfolio compression. The CCP operator is responsible for the design and functioning of this system, and primarily has operational and business risks. • T he differences in the risk profile of the CCP operator and the clearing members are reflected in the resources that they hold against their risk exposures. The resources of the CCP operator are designed to protect against operational and business risks and, if necessary, to manage an orderly wind- down. The resources of the clearing members are designed to help manage a member default. 3 • I n some CCPs, the operator also allocates a portion of own resources (referred to as “skin in the game”) to the member default waterfall. Its purpose is to align the incentives of the CCP operator with those of the clearing members. Skin in the game is not designed to be a material component of loss absorption. However, at 25% (as prescribed in EMIR), it is a material percentage of the CCP operator’s regulatory capital, and thus achieves the appropriate alignment. Any requirement for the CCP operator to contribute significant additional resources to the default waterfall and link them to the overall member exposure would fundamentally change the operator’s risk profile, creating increased risk exposure to member default at the very time that the operator should be resilient in order to ensure continuity of the clearing service and stability of the market. • T he total loss-absorbing capacity of a CCP is essentially the level of prefunded and contingent resources that are available to the CCP operator to manage a clearing member default. The resources – whether prefunded or not – must be provided by the clearing members. The CCP is a mutualized risk structure for the members, and the risk of a default must therefore be borne by the members. Figure 1 TLAC of a CCP CCP MEMBER CCP OPERATOR • Operational Risk RISK • Business Risk • Member Default TYPES • Collateral & Liquidity Management • Defaulter’s Initial Margin & Default Fund Contributions • Regulatory Capital PRE-FUNDED G N • Mutualised Default Fund I S B E R C O R • Assessment Powers • Insurance S U B O CONTINGENT • Variation Margin • Other • Other A S Gains Haircutting E S R S O L PROVIDER • CCP Member • CCP Operator R ES PRE-FUNDED • Skin in the Game O V T I A T R N E E P C O N PROVIDER • CCP Operator I 4 1. Risk Management The Committee on Payment and Market Infrastructures and International Organization of Securities Commissions’ (CPMI–IOSCO’s) principles for financial market infrastructures (PFMI) provide the foundation for CCP risk management. They are designed to ensure that CCPs have sufficient prefunded financial resources to withstand a clearing member default, even in extreme but plausible circumstances. Under the PFMI, CCPs with more complex risk profiles or that are systemically important in multiple jurisdictions must maintain financial resources sufficient to cover the simultaneous default of the two participants, and their affiliates, to which the CCP has the largest exposures (so-called Cover 2). The PFMI provide the minimum risk management standards that a CCP should apply. However, LCH.Clearnet has chosen to go further. For example, the methodology for calculating initial margin that a CCP should collect from its members is set in the PFMI, which require a minimum 99% confidence level for all products. In Europe, EMIR requirements go further, with a minimum 99.5% confidence level for OTC derivatives. LCH.Clearnet has chosen a margin beyond even the highest of the regulatory minimum requirements. We apply a confidence level of 99.7% across all our products. CCPs have been criticized for a lack of transparency in their risk management methodologies. We believe it is important for CCPs to provide sufficient information to enable their clearing members to conduct their own due diligence. We look forward to publication of CPMI-IOSCO quantitative transparency standards and would encourage all CCPs to implement them so that market participants are able to compare risk management practices and make informed decisions on where to clear their business. We are also supportive of standardized stress tests of CCP risk management methodologies and believe that disclosure of the results could help increase confidence in CCPs and identify best practices. Developing a stress test methodology will not be without its challenges, and some form of global coordination may be necessary. However, in our view, the benefits would be significant in enabling regulators and market participants to come to an informed view of the relative strength of each CCP. LCH.Clearnet would welcome the opportunity to engage with policymakers in the development of a harmonized stress testing methodology. 5 2. Recovery Tools CCP operators must have the necessary tools available to deal with the unlikely event that prefunded resources are not sufficient to manage a clearing member default. CCP operators should also have recovery tools to deal with a nondefault loss that could potentially arise as a result of operational disruption or business risk. We strongly believe that CCP recovery tools should be developed in consultation with clearing members and their clients, and agreed upon ex ante. Recovery tools, and the triggers for their use, should be transparent and predictable so that clearing members, their clients and the shareholders of the CCP can understand in advance how they will be applied. While a CCP operator must retain some flexibility to deal with the particulars of any given situation, market participants and regulatory authorities should have a full understanding of, and confidence in, the actions that it will take to recover after a major default. There must also be certainty and transparency around the size of any contingent liabilities. CCP recovery plans cannot assume the liability of clearing members is unlimited. In the event of a clearing member default, a CCP operator should cap the number of additional cash contributions it requests from surviving members. In addition, where a CCP exercises a recovery tool such as variation margin gains haircutting, we believe any net recoveries it makes from the estate of the defaulter should be used to reimburse surviving clearing members. 3. Resolution Resolution planning is also essential. Although the risk is remote, there may be circumstances where the recovery measures undertaken by the CCP operator have failed to restore the viability of the clearing service or have not been implemented in a timely manner, or where the resolution authority determines that the CCP’s recovery measures are not reasonably likely to return the CCP to viability or would be likely to compromise financial stability. In any of these cases, the resolution authority will be required to step in to take over management of some or all of the CCP in order to prevent the CCP ceasing to operate and entering disorderly liquidation, and to ensure that trading/markets are not disrupted. In our view, CCP resolution will be most effective if it is led by the resolution authority of the jurisdiction in which the CCP is established. Resolution will require rapid decision making, and the home resolution authority will be most familiar with the CCP’s operations and able to act decisively. Of course, any successful resolution will require close cooperation between the home resolution authority and the resolution authorities of those jurisdictions where the CCP provides clearing services. We therefore support guidance from the Financial Stability Board (FSB), which envisages coordination taking place through crisis management groups comprising the relevant supervisors, central banks and other public authorities. 6 As regards resolution tools, the risks to which a CCP can be exposed are very different than those of a bank or other financial institution. It therefore follows that the resolution tools will be different as a result. For example, bail-in is not appropriate for a CCP model. CCP operators are typically equity funded and are obliged to hold high-quality, liquid resources. Instead of obliging the CCP operator to raise debt or contingent equity simply in order to be able to bail in, the priority should be to ensure that the operator’s regulatory capital is sized correctly in the first instance, and that members’ initial margin and default fund contributions are also calibrated correctly. Conclusion Post-crisis regulatory reforms have done much to strengthen the resilience of the financial system, and banks in particular. Clearing members themselves are now subject to recovery and resolution regimes, and this has benefits for CCP resilience. If a bank's liabilities to a CCP are not subject to bail-in, then the CCP would have the absolute benefit of the member's own recovery and resolution resources prior to reaching the start of the CCP waterfall. As we have explained above, the majority of a CCP's total loss-absorbing capacity comes from its clearing members. The purpose of skin in the game is to align the incentives of the CCP operator with those of the clearing members. Any requirement for the CCP operator to contribute significant additional resources to the default waterfall would fundamentally change the operator's risk profile, creating increased risk exposure to member default at the very time that the market needs the operator to be resilient. This would also result in the CCP operator becoming an active part of the risk structure, which clearly would be detrimental to financial stability. Initial margin must therefore remain the first and most important defense and must be sized, along with default funds, to ensure that sufficient prefunded resources are available to manage the risk of a member default. It is vital that each CCP's risk management methodology is robust and that margins are calculated in accordance with the highest risk management standards. Greater transparency of risk management methodologies and disclosure of the results of a standardized stress testing regime will increase confidence in the resilience of the CCPs and enable clearing members to make an informed decision on where they choose to clear. 7 Introduction At their Pittsburgh Summit in 2009, Group of 20 (G20) leaders committed to strengthening the derivatives markets by encouraging greater central clearing1. The aim was to promote financial stability by mitigating counterparty credit risk through the use of central counterparty (CCP) clearing infrastructure, which had operated effectively during the financial crisis. For example, at the height of the crisis in 2008, LCH.Clearnet successfully managed the default of Lehman Brothers, one of its clearing members with a significant over-the-counter (OTC) derivatives position, without drawing upon any mutualized member resources. G20 members have worked to implement their commitment to increased central clearing, with the greatest progress in the United States, Canada, Europe, Australia and Japan. In the United States and Japan2, mandatory clearing requirements are already in effect for certain interest rate swaps (IRS) and credit default swaps (CDS). In Europe and Australia, the authorities have consulted on clearing obligations for IRS, and the expectation is for mandates to come into effect in 2015. Europe has also consulted on mandatory clearing of CDS and certain foreign exchange (FX) derivatives. FIGURE 2 CCP Clearing Progress The latest BIS semi-annual OTC derivatives statistics indicate the market has progressed materially from clearing around one third of interest rate derivatives (34%) when Dodd-Frank was enacted in summer 2010 to now clearing around two thirds (71%). H2 2014C dCaPta CaLvaEilAabRlIeN toG O PctRoObeGr RnoEt SinScluding Uncleared Options or Uncleared IRS, FRA 450 80% 400 70% 71% D tn) 350 56% 63% 60% S 300 U 53% 50% AL ( 250 36% 37% 39% 45% 40% N 200 31% 34% O OTI 150 21% 26% 30% N 100 16% 20% 50 10% 0 0 8 8 9 9 0 0 1 1 2 2 3 3 4 4 0 0 0 0 1 1 1 1 1 1 1 1 1 1 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 2 2 2 1 2 2 2 1 2 2 2 1 2 2 2 1 2 2 2 1 2 2 2 1 2 2 2 H H H H H H H H H H H H H H CLEARED CCP UNCLEARED IRS, FRA UNCLEARED OPTIONS CCP % 8 Mandatory clearing, and additional capital incentives under Basel III, will increase the concentration of derivatives activity in CCPs. It is therefore vital that regulators and market participants have confidence in each CCP’s risk management procedures and ability to manage a default. The risk management framework for day-to-day running of CCPs is well established. The Committee on Payment and Settlement Systems and International Organization of Securities Commissions’ (CPSS–IOSCO’s) principles for financial market infrastructures (PFMI) set global minimum risk management standards, which CCPs may choose to exceed3. In Europe, these principles have been implemented through the European Market Infrastructure Regulation (EMIR), which provides the regulatory framework for the authorization and operation of CCPs. In the United States, they have been taken forward through the Commodity Futures Trading Commission’s (CFTC’s) Part 39 rules, including Subpart C of those rules, for derivatives clearing organizations (DCOs)4. CPMI-IOSCO and the Financial Stability Board (FSB) have also developed guidance on CCP recovery and resolution5. In broad terms, a CCP’s recovery plan will be triggered when the prefunded financial resources available under its risk management framework have been exhausted. Resolution will be triggered when the CCP’s recovery tools have been exhausted, or when the authorities decide the recovery tools have not been implemented in a timely manner or are insufficient to restore the CCP’s viability. LCH.Clearnet fully supports efforts to CCPs offer state-of-the-art strengthen the resilience of CCPs. This margining and risk management paper explains our current risk management methods that do not exist to procedures and sets out our views on the key the same extent in the bilateral principles that we believe should underpin the world, which either relies on regulatory frameworks for CCP recovery and standardised margining methods resolution. that are not very risk-sensitive or on bank-internal margining models that may not necessarily meet the same high standards that CCPs are required to meet. Benoît Cœuré European Central Bank 9