Sunday, May 10, 2020
Last Monday, the Financial Stability Board (FSB) released the consultative document, Guidance on financial resources to support CCP resolution and on the treatment of CCP equity in resolution (here). As readers know, I’ve written several times about clearinghouses, the central feature of the G20’s reforms to the over-the-counter derivative markets following the 2007-08 crises, implemented in the US in Dodd-Frank’s Title VII (for example, here and here).
The Guidance’s title is a succinct encapsulation of its two-part focus. In the first part, it uses a five-step process to evaluate the adequacy of a CPP’s resources and available tools to support its resolution (were that to prove necessary). These steps include:
Step 1: identifying hypothetical default and non-default loss scenarios (and a combination of them) that may lead to resolution;
Step 2: conducting a qualitative and quantitative evaluation of existing resources and tools available in resolution;
Step 3: assessing potential resolution costs;
Step 4: comparing existing resources and tools to resolution costs and identifying any gaps; and
Step 5: evaluating the availability, costs and benefits of potential means of addressing any identified gaps.
In the second part, the Guidance focuses on how to treat CCP equity in resolution. A resolution of a CCP would be distinct from a “wind down” of the CCP. Readers might ask why one would have to think about such a thing – equity will likely get wiped out, right? Not necessarily. Today, most CCPs are shareholder-owned, but the CCP users/customers (clearing members) are mostly on the hook for any losses resulting from a user’s default. As I’ve written about in Incomplete Clearinghouse Mandates (here), this creates a foundational incentive problem because the shareholders benefit from the CCP’s profits, but the users are primarily responsible for any default losses.
As the Guidance notes, in theory, CCPs could experience losses due to user defaults, non-default issues, or a combination of both. How CCPs owned by shareholders will allocate losses between themselves and users in a “combination” scenario is completely unclear (allocation of non-default losses is also unclear in many cases) and should be addressed as I’ve noted before (here). Should the combination scenario arise, I think loss allocation will prove to be an intractable problem.
In reading the second part of the Guidance, one realizes how complicated and legally fraught the question of CCP equity could be in a resolution given the status quo. Towards the end of the second part, the Guidance states that:
Based on the analysis undertaken in accordance with the previous sections, the relevant home authorities should address the challenges relating to CCP equity fully bearing losses in resolution. This may include, where possible, that home authorities having the relevant powers and authority require that CCPs modify their capital structures, rules or other governance documents in a manner that subordinates shareholders to other creditors or sets out the point at which equity absorbs losses in legally enforceable terms. This may also include identifying or proposing potential changes to laws, regulations or powers of the relevant supervisory, oversight or resolution authorities that would enable achieving the resolution objectives or limit the potential for NCWOL claims.
In the short term, the last sentence of this quote likely offers a more feasible approach to handling CCP equity than what I think would be a more sensible approach: addressing the ownership structure of these institutions. This would almost certainly be much more difficult to implement in practice, but it’s ultimately a simpler, more sensible long-term solution for addressing CCP equity in resolution and for addressing loss allocation under a combination scenario. Until we fix this foundational issue of ownership, we shouldn’t be surprised if the path of a distressed, systemically significant clearinghouse ultimately resembles that of the government‐backed mortgage lenders whose fate more than 11.5 years after entering government conservatorship still remains uncertain. Let’s not repeat this history!