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CCP RECOVERY and RESOLUTION

A PERSPECTIVE FROM MARKET MAKERS

Optiver, as one of the largest market making firms in the world, supports legislation that gives regulators and CCPs effective tools to ensure CCPs’ functions are preserved in times of crisis

Recovery and resolution of an ailing CCP should be viewed as a public utility function, requiring ex-ante guidelines and principles for the use of all tools with a focus on balancing the interests of all involved stakeholders and avoid cost to taxpayers

Participants need transparency over the criteria for use of specific recovery tools and the scope of their application

VMGH and partial tear-ups could disproportionately affect market makers which have hedged positions. They introduce contagion effects with systemic implications that could lead to new defaults of investment firms and clearing members that are connected to other CCPs

Tear-ups (full and partial) and VMGH are actually so impactful that we believe they should only be used in resolution situations. Also tear-ups could potentially ‘jump’ the waterfall. We feel therefore that cash calls are the preferred tool for recovery.

To reduce systemic risk, an exemption from applying VMGH and tear-ups for any trade done under a MiFID II regulated market making agreement should be considered.

1. Introduction

CCPs perform a critical role in financial markets. We welcome the legislative proposal by the European Commission to ensure that CCPs and national authorities have the means to act decisively when a CCP falls into a crisis scenario. The proposed rules will contribute to the aim of ensuring that CCPs’ critical functions are preserved while maintaining financial stability. They will also help to avoid the costs associated with the restructuring and the resolution of failing CCPs being transmitted to taxpayers.

When developing an effective recovery and resolution framework for CCPs, colegislators should ensure that the use of recovery and resolution tools included in the CCP R&R toolkit factors in an appropriate balance of the interests of the CCP, the clearing members, and the participants. This in turn also means that lossallocation in recovery should be proportionate to the risks posed by participants to the CCP and that loss allocation should be capped, with the ultimate objective of limiting contagion and systemic risk.

If a CCP runs into trouble it will be in a period of serious market stress. During such periods of market turbulence, it is critical that market makers can remain in the market to provide liquidity to prevent markets to come to a complete standstill. When designing the toolkit for recovery and resolution of CCPs it is therefore fundamental to ensure that those tools do not force markets makers to stop providing the necessary liquidity

2. Aligning incentives

To align incentives of the CCP with other market participants, one of the tools that could be used is “Skin-in-the-game (SITG)”. SITG mandates CCPs to use a dedicated amount of own resources that is equivalent to its minimum capital requirement prior to applying position and loss allocation tools for default losses. As stipulated by EMIR this SITG is set at 25% of the CCP equity, which creates incentives for CCPs shareholders to keep equity low. Allowing for further own resources of the CCP to be used in recovery and resolution (before exhausting the default waterfall and utilising position and loss allocation tools) would signal to participants that the CCP has strong confidence in its risk management processes. It would better align the incentives of the CCP with those of its participants. The amount of SITG should not be related to equity, but be based on a standard valuation model, taking into account the peak risk position within the CCP over a specified lookback period. 

Equally, to contribute to an alignment of incentives amongst market participants the allocation of losses should be proportionate to the risks posed by the participant to the CCP.

3. Guiding principles for use of toolbox

In order to minimise market instability in the event of a recovery and resolution scenario, market participants (and clearing members) need to to have ex-ante clarity over what tool box is applicable at a CCP and what the procedures and criteria are for deploying individual measures in the toolkit. A CCP’s rulebook should provide clarity to participants over what triggers the use and scope of individual recovery tools and what pricing references will be used in loss-allocation. Overall, as part of creating recovery and resolution frameworks for CCPs, clearing participants need to have more clarity over the timing of entry into resolution – e.g. move from recovery phase and attempting to restore the CCP to a matched book to resolution. 

To provide participants with more certainty, any use of recovery tools should ensure a balancing of the interests of all stakeholders, allocate losses in a proportionate manner to the risks being brought to the CCP by each participant, and cap the overall amount of losses that can be allocated with the ultimate objective of reducing systemic risk. 

In the Annex to this paper we have assessed the different recovery and resolution tools based on these principles. In the rest of this paper we would like to share our concerns on two specific tools, which – if not applied with the necessary caution – could actually introduce more systemic risk in the financial system.

4. Tools that may increase systemic risk

Use of Variation Margin Gains Haircutting (VMGH) or partial tear-up of contracts as recovery and resolution tool could have destabilising effects on the wider financial ecosystem and – in the case of VMGH – undermine the No-Creditor-Worse off (NCWO) principle. Application of both tools could also disproportionately affect market makers and undermine their ability to provide crucial liquidity in stressed market conditions.

4.1 use of vmgh

CCPs settle the gains and losses of members’ futures positions on a daily basis, with either the buyer or the seller of a futures product receiving variation margin depending on whether the price of the future has gone up or down. 

Market Making firms typically have fully hedged positions, meaning that the futures position in one CCP will be hedged with an offsetting position in a different but related product (potentially with a different CCP). So the variation margin ‘gains’ of a market maker is never a profit, but a hedge for a loss making position. This is important to take into account at it has important implications for the potential systemic impact of applying VMGH:

Randomness

For market making firms (and other institutions that have hedged positions) the
impact of VMGH is completely dependent on (1) which products they have traded
(e.g. options or futures) and (2) which side of the trade they are on (buyer or seller).

Some market makers will be completely unaffected by VMGH, while others will be
potentially put out of business, creating an element of randomness in the impact of
the tool. For that last group winding down the CCP under normal bankruptcy rules
would have been more attractive, as it would have allocated losses more evenly
amongst market participants. VMGH in this sense also undermines the NCWO
principle.

Smaller base

Also, and from a more practical point of view, as VMGH only applies to “gains” on only futures products, the base for recouping funds for the CCP is much smaller than in the case of other recovery and resolution tools.

Contagion risk

If a CCP is in financial trouble, it will most likely be in a period of financial stress, potentially with multiple clearing members defaulting more or less simultaneously on their financial obligations. In those circumstances market volatility and volumes are likely to be very high, with extremely large variation margin ‘profits’ and ‘losses’ on futures positions. Applying VMGH on the positions of market makers in such a situation risks that these market makers will default on their obligations arising from the loss-making counter (hedge) position. This could subsequently bring down clearing banks who have guaranteed these market makers’ positions and introduce contagion risk towards other CCPs.

4.2 use of partial tear-ups

Equally, whilst using tear-ups – e.g. tear-ups of the contracts of the defaulting clearing member within a product group (i.e. partial tear-up) – as a position allocation tool that only targets the non-auctioned positions could enable the CCP to continue clearing a product group, it could also create unforeseen market risks, particularly in the case of partial tear-ups. Like VMGH, partial tear-ups could unbalance the portfolios of clearing participants (including market makers operating with a fully hedged portfolio). Such partial tear-ups could lead to fully hedged positions of market makers becoming unhedged because one of the legs of a hedging pair or multiple legs of a hedging strategy are torn up. Just like the application of VMGH, PTU risks the default of market participants with potential systemic contagion effects that could jeopardise clearing members and other CCPs. Therefore, a situation where the where the resolution authority cancels all contracts in a certain product segment (i.e. full tear-up), are preferable over partial tear-ups. 

Partial tear-ups also risk disproportionately affecting participants over clearing members as clearing members do not hold positions with the CCP (so they will always prefer tear-ups). It also risks undermining the auction process because there would be limited incentives for clearing members to bid in the auction process when the CCP is liquidating the positions of the defaulting clearing member(s).

4. proposed way forward

As we have explained above, tear-up of contracts (both full and partial) and VMGH are so impactful that we feel they should not be used in recovery situations. We feel that cash calls are the preferred instruments in recovery scenarios. 

Under MiFID II all market makers have an obligation to enter into a market making agreement, and all orders sent to an exchange under that agreement should be flagged as such. Thus it is very easy to identify all transactions that will have an associated hedge position. Excluding from applying VMGH or tear-ups those trades that were done under a regulated MiFID II market making agreement (and flagged as such) will limit the potential contagion risks associated with these tools and ensure that market makers will not be forced to stop fulfilling their essential role as liquidity provider in times of market crisis.

About optiver

Over thirty years ago, Optiver started business as a single trader on the floor of Amsterdam’s European Options Exchange. Today, we are a leading technology-driven market maker, with more than 1000 employees in offices around the world, united in our commitment to improve the market by competitive pricing, execution and thorough risk management. By providing liquidity on multiple exchanges across the world in various financial instruments we participate in the safeguarding of healthy and efficient markets.
We provide liquidity to financial markets using our own capital, at our own risk, trading a wide range of products: listed derivatives, cash equities, ETFs, bonds and foreign currencies.

annex |
a prospective assessment of CCP recovery and resolution tools

Loss Distribution/ Cash Calls

Description

Allocation of default losses in excess of the Default Waterfall to surviving members.

Circumstances for use by CCP

After the successful close-out of the defaulter’s positions (“return to a matched book”) by the CCP.

Benefits

Fair way of allocating losses to the industry, based on the common interest in continued provision of clearing services.

Potential Shortfalls

(i) Losses passed over to Clearing Members only; (ii) Allocation rules based on a netted exposure metric (e.g. IM for NOSA accounts) (iii) Uncapped liabilities for the industry.

Guidelines for implementating

Clearing Members
should be able to
pass through Loss
Distribution proceeds
to their clients.

The amounts of
loss distribution or
size of the cash call
should be based
on the members’
contribution to the
CCP’s risk (e.g. cash
call based on the
amount of the IM).

Total distributed
losses should
be capped to a
quantifiable level

Full Tear-Up

Description

Tear-up of all contracts within the same Product Group level.

Circumstances for use by CCP

In case of: – outstanding defaulter’s positions, which cannot be closed-out in an acceptable fashion; – determination by the CCP that realized/ potential losses from the liquidation of defaulters’ positions are/would be more than the available funded and unfunded resources.

Benefits

Application to the whole industry based on open positions. Fair treatment of hedged positions within a Product Group as the full strategy gets torn up

Potential Shortfalls

(i) Losses may be allocated directly to participants, without using default fund resources first. Thi s would typically be the case if the CCP opts for a Tear-Up mechanism instead of liquidating the defaulter’s portfolio at an extremely discounted price. (ii) May create a disincentive for Clearing Members to bid in liquidation auctions. (iii) Definition of Product Group may be done at the wrong granularity level (too restrictive or too wide).

Guidelines for implementating

Before tear-ups (full or partial) the default should have been depleted to ensure that not only the participants, but also the CMs are contributing. FTU should only be used as a last-resort measure to discontinue certain market sections when: (i) there is reasonable proof of material dysfunction in the price discovery mechanism (“illiquid markets”); or when (ii) the extent of losses from one or several members’ default make it economically impossible to continue operating the clearing service.

IMH

Description

Use of part or all of the Initial Margins posted by surviving members to absorb excess Default Losses.

Circumstances for use by CCP

After the successful close-out of the defaulter’s positions (“return to a matched book”) by the CCP.

Benefits

Alternatively: – After the successful close-out of the defaulter’s positions (“return to a matched book”) by the CCP; Fair way of allocating losses to the industry, both as IM is a fair assessment of the risks contributed to the system, as well as a reflection of the commitment of surviving parties to the survival of the CCP. Losses are limited to the amount of IM at the CCP.

Potential Shortfalls

The IM posted to the CCP constitutes collateral to guarantee against the default of a member. Use of that collateral to cover default losses in recovery therefore defeats the original purpose of IM.

Guidelines for implementating

A superior and maybe acceptable alternative could be a cash call mechanism whereby the size of the cash call is based on the members’ contribution to the CCP’s risk (i.e. cash call based on th

VMGH

Description

Margin adjustment applied to MTM gainers only

Circumstances for use by CCP

Alternatively: – After the successful close-out of the defaulter’s positions (“return to a matched book”) by the CCP; – Upon determination by the CCP that realized/ potential losses from the liquidation of defaulters’ positions are/would be in excess of the available funded and unfunded resources.

Benefits

The money is already available at the CCP. Enables the CCP to cover potential further mark-to-market losses from outstanding defaulters’ positions.

Potential Shortfalls

Creates a strong contagion risk. Market makers may have large VM at a CCP that effectively is a hedge for another position at another CCP. Haircutting that hedge may lead to defaults at other CCPs. It uses a smaller base than all other methods. This goes contrary to the goal of mutualisation, as it is a loss-allocation to specific participants. Randomness is reinforced by the fact that VMGH is applied at account/clearing member level. End clients with exactly the same positions clearing through different clearers may or may not be subject to VMGH depending on the makeup of the clients’ portfolio of a given clearing member. Application may be done at the wrong granularity level (too restrictive or too wide), exposing hedged strategies to VMGH.

Guidelines for implementating

Should only be applied after the losses are certain (i.e. after returning to a matched CCP book) VMGH should in any case always be applied at portfolio level and not at instrument level. The application of VMGH should be capped in duration and amount.

Partial Tear-Up

Description

Tear-up of only a subset of contracts within a Product Group.

Circumstances for use by CCP

In case of outstanding defaulter’s positions, which cannot be closedout in an acceptable fashion.

Benefits

The money is already available at the CCP. Enables the CCP to cover potential further mark-to-market losses from outstanding defaulters’ positions. Application to the whole industry based on open positions. Partial tear-up may help maintain the clearing of a product group by only targeting illiquid positions

Potential Shortfalls

Stong contagion risk like VMGH. Partial tear-ups may not only lead to substantial losses for participants, but also create massive (new) markets risks as it has the potential to create an unhedged leg or several legs of a previously fully hedged strategy (e.g. options vs futures, calendar spreads). This could increase the risk of further defaults of market participants and thus create additional systemic contagion effects. This creates a disincentive for Clearing Members to bid in liquidation auctions

Guidelines for implementating

Before tear-ups (full or partial) the default should have been depleted to ensure that not only the participants, but also the CMs are contributing. Partial tear-ups should only be used: 1) to close-out specific illiquid positions after proven total failure of liquidation auctions (i.e. no bids submitted at all); and 2) if it has been determined that application of rejected auction prices would trigger losses beyond the default waterfall.

Willem Sprenkeler

Head of Public Affairs

Claire Nooij

Manager Public Affairs & ESG