Sunday, May 31, 2020
This past week, I had occasion to return to the Financial Stability Board’s (FSB) recent Consultative document, Guidance on financial resources to support CCP resolution and on the treatment of CCP equity in resolution (Guidance), which I wrote a brief post about several weeks ago (here). In doing so, I spent more time thinking about the possibility of clearinghouse shareholders raising “no creditor worse off than in liquidation” (NCWOL) claims in a resolution scenario. I’m struggling with this idea. Shareholders are not creditors. I’ve decided to research this issue more and plan to write a short article. Stay tuned.
The Guidance notes the principle:
that in resolution CCP [clearinghouse] equity should absorb losses first, that CCP equity should be fully loss-absorbing, and that resolution authorities should have powers to write down (fully or partially) CCP equity.
It also notes that:
actions in resolution that expose CCP equity to larger default or non-default losses than in liquidation under the applicable insolvency regime could, based on the relevant counterfactual, enable equity holders to raise NCWOL claims. This may be inconsistent with the other Key Attributes principle that equity should be fully loss absorbing in resolution. This may also raise moral hazard concerns by allowing equity holders to maintain their equity interest in a CCP post resolution while participants are made to bear losses.
Most clearinghouses – for example ICE Clear Credit, a clearinghouse for CDS, and CME Clearing, a clearinghouse within CME Group – are now part of publicly traded global exchange group structures. Historically, clearinghouses were owned by their users/participants. Post Dodd-Frank, some clearinghouses, including the two just noted, have been designated as systemically significant financial market utilities (here).
Over a long period of time, clearinghouses have proven themselves to be robust risk management institutions. However, they can and have failed. Clearinghouses can experience losses due to the default of a clearing member(s), due to non-clearing member default issues (for example, cybersecurity problems, investment or custody losses, operational problems etc.), or due to a combination of both default and non-default issues.
Clearinghouses have rulebooks (contractual arrangements between the clearinghouse and clearing members/participants) that delineate how losses will be handled in the event that a clearing member were to default. Typically, clearinghouse default waterfalls in rulebooks direct that if the defaulting member’s performance bond (initial margin) does not cover its obligations, then a limited amount of funds contributed by the clearinghouse itself would be used to cover losses, and then any remaining losses would be covered by a common default fund which all clearing members are required to contribute to. Were the default fund to be exhausted, rulebooks generally permit clearinghouses to make an additional “cash call” to members. Were losses then still outstanding, the clearinghouse would initiate a recovery process.
Clearing members have called for clearinghouses to put additional capital at risk in this default waterfall structure (here) and to be required to hold additional capital. There is an obvious tension/conflict of interest between clearing members of a publicly traded clearinghouse being largely responsible for default losses and the clearinghouses's shareholders benefiting from the clearinghouse’s profits and managing its risk. Of course, if clearinghouses were owned by their users as they were historically, this conflict of interest would not exist. An alternative to the remutualization of clearinghouses would be for the clearinghouse to be responsible for any default losses that exceeded the defaulting member’s initial margin. From my perspective, this would make a lot more sense. I'm unaware of other examples in which the customers (clearing members) of a publicly traded institution, rather than its shareholders, are responsible for losses created by other customers.
Were a systemically important clearinghouse to become distressed, a resolution authority (RA) could step in – perhaps prior to the completion of the clearinghouse’s recovery process – to ensure the continuity of the clearinghouse’s operations and financial market stability. Systemically important clearinghouses are too critical to fail. Were the RA to take actions resulting in the shareholders experiencing larger losses than they would “in liquidation under the applicable insolvency regime,” there is a concern that such action by the RA could “enable equity holders to raise NCWOL claims.” I would think that this concern would largely disappear if the odd situation of having customers paying for the losses of other customers at a publicly traded institution did not exist or if clearinghouses were owned by their users.
At least for now, in my pre-NCWOL claims by clearinghouse shareholders article world, it’s unclear to me why given that shareholders are not creditors that shareholders would (or should) be able to make credible “NCWOL” claims as shareholders in resolution. I understand that a RA could step in before a clearinghouse recovery process were complete and that shareholders might lose more than they would were the rulebook procedures followed. I also understand that clearinghouse rulebooks generally require clearing members – rather than shareholders – to absorb the majority of the losses from the default of a clearing member. But at the end of the day, shareholders are simply not creditors. Perhaps if it were clear ex-ante that clearinghouse shareholders would be unable to make NCWOL claims in a clearinghouse resolution, it might help to rationalize the incentive conflicts in the clearinghouse area. If clearinghouse shareholders want to make “no shareholder worse off than in liquidation” claims, then the case should be made for that.