## wp1865

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---

### Introduction and policy context
- CCPs became central to risk management after uptake of clearing for OTC derivatives; post-crisis policy made clearing of standard OTC derivative products mandatory.
- Mandatory clearing plus concentration of counterparty risk increases risk of failure of the infrastructure itself; focus is on large CCPs that clear OTC derivative products under new mandates.
- Recent initiatives and proposals referenced include CPMI, FSB (2014, 2016, 2017), a draft EU Regulation (European Commission, 2016), and private-sector contributions (JP Morgan (2017), LCH (2014), ISDA (2013b, 2017a)).

### CCP function and the waterfall of resources
- CCP becomes central counterparty (buyer to every seller and vice versa), taking margin and a contribution to its default fund to manage assumed risk.
- When a clearing member (CM) defaults, the CCP must continue performance to non-defaulting participants and replace the defaulter’s positions (re-balance its book).
- Waterfall of resources (Box 1):
  - First: margin provided by the defaulter.
  - Next: default fund plus CCP’s own resources (“skin in the game”).
- End-of-waterfall scenarios occur when initial margin, default fund, and skin-in-the-game are consumed; such catastrophic events necessitate recovery and resolution planning.
- Box 1 summary: After contributions of surviving CMs are utilized, the “end of the waterfall” is reached, and other contributions are needed.

### Situations where the waterfall may be inadequate (Box 2)
- Auction failure: non-defaulting CMs fail to bid acceptably (lowest prices bid exceed available CCP financial resources).
- Liquidity demands: CCP must continue to pay variation margin, register new transactions, and rebalance while not shut down.
- Illiquidity vs insolvency: CCP inability to meet obligations when due can be equivalent to insolvency because CCPs lack long-term assets to call in.

### Non-default losses (Box 3)
- Origin and quantum of non-default losses are hard to model; network theory and loss-distribution models have limited value (Glasserman and Young, 2017).
- Debate continues on access to central bank liquidity.
- Non-default losses do not impugn the CCP’s risk model; a “lift-out” (transfer of the CCP’s clearing operation to a clean vehicle) may be feasible. The resolution toolkit may be more effective for such cases, though requiring CMs to bear operational losses is controversial.
- The paper does not analyze the proposed resolution toolkit as applied to non-default losses.

### Stakeholders, incentives, and economics
- Mandatory clearing makes the clearing function akin to a public good or “essential function” (FSB 2017), but CCPs are not government-owned or public-capitalized.
- A utility typically has (a) a government backstop and (b) negotiated economic rents; CCPs lack these two characteristics in full.
- Revenues from OTC derivatives comprise three elements: the origination fee, netting on books, and the clearing fee. In a cleared environment, banks retain the origination fee and some netting benefits.
- For CCPs to be true utilities the full spectrum of economic rents would need to be negotiable, but banks will not relinquish origination fees or netting.
- The mix of incentives among CMs, CCP operators/owners, and government/taxpayer complicates predictable outcomes under stress; resolution proposals must be sensitive to these tensions.

### Recovery and resolution — definitions and distinctions
- FSB objective for CCP resolution: “CCP resolution should have as its objective the pursuit of financial stability and ensure the continuity of critical CCP functions in all jurisdictions where those functions are critical and without exposing taxpayers to risk of loss.” (FSB, 2017)
- Recovery: process restoring a troubled but not fatally injured institution to health; often involves capital transfusion or liability equitization/write-off and requires advance planning and swift implementation.
- Resolution: invoked when recovery has failed or is pointless; for banks it preserves critical functions by separating them from causes of failure and avoids detrimental liquidation to the wider economy.
- CCPs differ materially from banks: they do not take deposits, make loans, trade for account, or perform commercial bank roles. These differences limit the applicability of bank resolution toolkits to CCPs and imply potentially faster timeframes for CCP resolution.

### Conflation of recovery and resolution for CCPs
- FSB’s Guidance emphasizes continuity of essential CCP functions and restoring the CCP as a going concern, blurring the line between resolution and a second round of recovery.
- For banks, a “lift-out” of uncontaminated critical functions is common; for CCPs, catastrophic default loss usually means failure of the risk model, making lift-out “nigh impossible.”
- Without a feasible lift-out, restoring critical functions as a going concern requires correcting the CCP’s balance sheet — an action more akin to recovery than end-of-life resolution.
- Treating continuity of critical functions as the primary objective of resolution effectively merges resolution with recovery and may be conceptually problematic.

### Review of policy for CCP resolution — scope
- The paper examines:
  - Whether CCP resolution should aim for full reinstatement as a business.
  - Governance and ownership of CCPs and assignment of responsibility for resolution.
  - The incidence of end-of-waterfall costs (concluding that, under current capital arrangements, CMs must bear end-of-waterfall costs).
  - Loss-allocation mechanisms, notably variation margin gains haircutting (VMGH).
  - The role and applicability of the “No Creditor Worse Off” (NCWO) principle as a normative check in CCP resolution.

### Governance and stakeholders — concluding points
- Key distinctions vs banks:
  - For banks, capital providers are not users; bondholders and equity owners are expected to take losses; retail depositors protected.
  - For CCPs, which have no retail customers, clearing members (CMs) are expected to bear losses.
- Governance features:
  - CCPs are governed by shareholders (owners) who set prices and have final say on the risk model; risk committees may influence margining and default fund size.
  - Costs of model failure (losses at end of waterfall) are effectively borne by stakeholders other than CCP shareholders under current practice.
- Capital and “skin in the game”:
  - CCPs must ensure owners have a slice of equity at risk, but this stake has been criticized as inappropriately low.
  - Total capital provided by equity investors is limited; parent companies of CCPs are often subsidiaries in infrastructure groups and are unlikely to issue convertible or loss-absorbing instruments in practice.
- Practical constraints on relying on parents/shareholders:
  - Convertible instruments unlikely to have been issued by CCP parents; regulators reluctant to expose other infrastructure entities in the group.
  - Resolving the parent would likely involve too small a financial sum to contain an extreme catastrophic loss that blew out a CCP’s default fund.
- Comparative figures (millions of U.S. dollars):
  - Market capitalization: 12,450  15,180 39,510 6,757
  - Long-term debt: 1,253 19,250 2,231 6,305
  - Default funds of CCP: 7,460 3,479 6,426 2,657
- Conclusion: Shareholders are not the answer under present regulatory capital rules; CMs (or taxpayers) will bear costs in some way.

### Resolution tools — survey and high-level findings
- Many proposed “resolution” tools are effectively loss-allocation/recovery tools and may be available as CCP recovery options (VMGH, cash calls).
- Lift-out approach for banks (removing viable business) does not map cleanly to CCPs because CCPs have no loan book or priority creditors.
- Summary of proposed tools:
  - Bridge CCP: inherits both “bad” and “good” positions; no realistic separation of losses.
  - Sale to competitor CCP: could transfer non-defaulting members’ positions but faces practical issues (balancing the book; readjusting margin/default fund contributions and membership eligibility; sourcing cash to take over loss-making book).
  - Position and loss allocation (write-down/tear-up of contracts): reduces CCP losses by canceling or neutralizing positions but undermines CCP function of ensuring counterparty performance.
  - VMGH (Variation Margin Gains Haircut): appears least unattractive among tools but has moral hazard and other objections.
  - Cash call: legitimate recovery tool; belongs in recovery phase; caps and practical limits on shareholder/CM contributions may render it ineffective by resolution stage.

### Variation Margin Gains Haircut (VMGH)
- Mechanism:
  - CCP withholds on-payment of gains to net gainers while continuing to demand variation margin from losers.
- Advantages:
  - Limited-use VMGH can keep CCP afloat with limited risk to CMs.
  - Provides an additional buffer before taxpayer involvement.
- Empirical scale and context (largest CCP net open interest positions cited):
  - Eurex Clearing AG: US$1.7 trillion open interest position
  - LCH.Clearnet Limited: US$164 trillion open interest position
  - CME Clearing: US$16 trillion open interest
- Comparable GDPs:
  - Germany GDP: US$3.4 trillion
  - United Kingdom GDP: US$2.5 trillion
  - U.S. GDP: US$20 trillion
- Risks and objections:
  - VMGH causes losses to market participants (including hedgers).
  - Potential for CM behavior changes that offload VMGH burden to clients.
  - Open-ended VMGH could create moral hazard and force participants to support a CCP despite loss of confidence.
  - VMGH might reinforce price spirals.
- Policy view:
  - Best balance is a single round of haircutting not subject to a financial cap, but additional checks and balances are needed to limit scale and duration and ensure fairness.

### No Creditor Worse Off (NCWO)
- Principle:
  - In bank resolution, tools should leave creditors no worse off than liquidation.
- Application to CCPs:
  - Creditors (CMs) must retain the option to liquidate the CCP; if CMs’ entitlements are unilaterally written down, they lose creditor status and the liquidation option.
  - A robust liquidation option enforces discipline and ensures stakeholders are not forced to perpetually support a failed CCP and its risk model.
- Concern:
  - Liquidation of CCPs is not officially contemplated; absence of liquidation could leave taxpayers as the ultimate backstop, undermining goals to avoid public funds.

### Overview of CCP resolution — findings and implications
- Lift-out approach is generally unworkable for CCPs; remaining options are loss-allocation tools that leave the failed risk model in place.
- CMs or taxpayers will bear the financial burden; CMs may be unwilling or unable to participate in recapitalization in a workable timescale.
- Market structure trends increasing risk concentration:
  - Over a 10-year period to 2015, number of Futures Commission Merchants (FCMs) in the U.S. fell by approximately 60 percent.
  - SwapClear CMs at LCH.Clearnet Limited grew four-fold (over 80 new members) in five years, but the top ten clearing brokers clear 97 percent of the market (top five, 70 percent).
  - Customer assets held by U.S. FCMs grew 45 percent between December 2007 and March 2015.
- Conclusion: A smaller number of CMs is being expected to shoulder a greater volume of risk; it is not obvious that CMs can absorb the potential quantum of loss—raising prospect of taxpayer involvement.
- If recovery fails and insolvency is non-viable, taxpayer bail-out may be the only remaining option.

### A revised policy approach — key proposals
A. The Clearing Obligation Should be Relaxed
- Rationale:
  - Mandatory central clearing of OTC derivatives is not always risk-reducing.
- Options proposed:
  - (a) Suspend the clearing obligation in cases of CCP difficulty on a global basis (FSB 2016), allowing bilateral clearing, portability, or other alternatives.
  - (b) Automatically cancel clearing mandate for products where a CM default has blown through the default fund layer for that product and do not reinstate until causes are understood and remedied.
  - (c) Ensure CMs can manage losses (e.g., ability to register offsetting trades); strengthen CCP reserves policies and revise loss waterfall.
- Monetary policy consideration:
  - Implementation of EU regulations on variation margin for uncleared trades was postponed; dealer banks’ balance sheet constraints and collateral transformation dynamics imply that pushing more derivatives to CCPs may build large central bank balance sheets.

B. CCPs Should Widen Sources of Capital, and Build Reserves
- Rationale:
  - CCPs that do not contribute proportionately to default management shift costs to CMs; incentives to clear via CCP vs bilateral clearing are weak or ambiguous.
- Proposals:
  - Encourage CCPs to add further sources of default backing into the waterfall before non-defaulting members’ default fund contributions are used.
  - Consider debt instrument issuance, default insurance, and other sources of default backing to contribute liquidity and loss-absorption capacity.

### Box 4 — Should Mandatory Clearing be Relaxed? (key excerpts)
- Netting benefits and CCP fragmentation:
  - Moving OTC derivatives to CCPs increases multilateral netting which can reduce required margin for a portfolio. Multiple CCPs that are not linked reduce netting benefits (Duffie and Zhu, 2009).
- Collateral ambiguity and estimated shortfalls:
  - There may be a shortfall of up to US$3–4 trillion (Singh, 2010, 2017).
  - ISDA (2017b) sources indicate about US$1.0 trillion of collateral dedicated to the bilateral market (and unrelated to bilateral clearing deficiency, about US$400 billion to the CCP market).
  - Financial statements typically capture only variation margin; reuse factor of 2.0 implies significant additional collateral will have to be posted as CCPs’ rights of re-use of initial margin are curtailed.
- Alternative policy: levy on residual derivative liabilities:
  - A levy on residual derivative liabilities (after netting and after collateral) is presented as a more transparent approach than mandating CCP clearing, with the objective that large banks minimize residual derivative liabilities.
- “Skin in the game,” CCP loss absorption, and reserves:
  - Official policy on quantification of “skin in the game,” and whether parent companies of CCPs should issue debt capable of bail-in, should be revisited.
  - CCPs should be required to develop reserves, and to declare publicly their reserves and dividends policy in relation to the default waterfall.
  - CCPs that fail to build reserves and then experience extreme losses could be required to claw back profits distributed irresponsibly.
- Failed CCPs should be scrutinized:
  - A CCP whose legally required financial resources prove insufficient has mismanaged its risks; causes of failure should be investigated by an entity other than the resolution authority and results published.
- Concluding policy implications:
  - Robust clearing infrastructure is important where mandated; the amount of financial underpinning is set by law and must be matched by predictable plans for when funds run out.
  - Present policy assumes costs of CCP resolution are borne by CMs or taxpayers; the risk/reward model for CCPs is unbalanced and should not be distorted by bank-style resolution assumptions.
  - Many proposed bank-style resolution tools may be unusable or counterproductive for CCPs; CPMI-IOSCO and FSB should modify recommendations to avoid assuming a bank-style resolution model is suitable for CCPs.
  - It is not too late for action to improve policy on failing CCPs.

*Source: wp1865 - Introduction (IMF Working Paper).*

### Introduction ...........................................................................................................

### Introduction

### Central role and policy context
- CCPs became central to risk management after uptake of clearing for OTC derivatives; post-crisis policy made clearing of standard OTC derivative products mandatory.
- Mandatory clearing plus concentration of counterparty risk increases risk of failure of the infrastructure itself; focus of this paper is on large CCPs that clear OTC derivative products under new mandates.
- Recent initiatives and proposals on CCP recovery and resolution referenced: CPMI, FSB (2014, 2016, 2017), and a draft EU Regulation (European Commission, 2016). Private-sector contributions include JP Morgan (2017), LCH (2014), ISDA (2013b, 2017a).

### CCP function and the waterfall of resources
- The CCP becomes the central counterparty (buyer to every seller and vice versa), taking margin and a contribution to its default fund to manage assumed risk.
- When a clearing member (CM) defaults, the CCP must continue performance to non-defaulting participants and replace the defaulter’s positions (re-balance its book).
- A “waterfall” of resources funds re-balancing (see Box 1):
  - First: margin provided by the defaulter.
  - Next: default fund plus CCP’s own resources (“skin in the game”).
- End-of-waterfall scenarios occur when initial margin, default fund, and skin-in-the-game are consumed; such catastrophic events necessitate recovery and resolution planning.
- Box 1: A Hypothetical Waterfall Situation — After contributions of surviving CMs are utilized, the “end of the waterfall” is reached, and other contributions are needed. (Source: ISDA (2013a).)

### Situations where the waterfall may be inadequate (Box 2)
- Auction failure: non-defaulting CMs fail to bid acceptably (lowest prices bid exceed available CCP financial resources).
- Liquidity demands: CCP must continue to pay variation margin, register new transactions, and rebalance while not shut down.
- Illiquidity vs insolvency: CCP inability to meet obligations when due can be equivalent to insolvency because CCPs lack long-term assets to call in.

### Non-default losses (Box 3)
- Origin and quantum of non-default losses are hard to model; network theory and loss-distribution models have limited value (Glasserman and Young, 2017).
- Debate continues on access to central bank liquidity.
- Non-default losses do not impugn the CCP’s risk model; a “lift-out” (transfer of the CCP’s clearing operation to a clean vehicle) may be feasible. The resolution toolkit may be more effective for such cases, though requiring CMs to bear operational losses is controversial.
- The paper does not analyze the proposed resolution toolkit as applied to non-default losses.

### Stakeholders, incentives, and economics
- Post-crisis mandatory clearing makes the clearing function akin to a public good or “essential function” (FSB 2017), but CCPs are not government-owned or public-capitalized.
- A utility typically has (a) a government backstop and (b) negotiated economic rents; CCPs lack these two characteristics in full.
- Revenues from OTC derivatives comprise three elements: the origination fee, netting on books, and the clearing fee. In a cleared environment, banks retain the origination fee and some netting benefits.
- For CCPs to be true utilities the full spectrum of economic rents would need to be negotiable, but banks will not relinquish origination fees or netting.
- The mix of incentives among CMs, CCP operators/owners, and government/taxpayer complicates predictable outcomes under stress; resolution proposals must be sensitive to these tensions.

### Recovery and resolution for CCPs — definitions and distinctions
- FSB objective for CCP resolution: “CCP resolution should have as its objective the pursuit of financial stability and ensure the continuity of critical CCP functions in all jurisdictions where those functions are critical and without exposing taxpayers to risk of loss.” (FSB, 2017)
- Recovery: process restoring a troubled but not fatally injured institution to health; often involves capital transfusion or liability equitization/write-off and requires advance planning and swift implementation.
- Resolution: invoked when recovery has failed or is pointless; for banks it preserves critical functions by separating them from causes of failure and avoids detrimental liquidation to the wider economy.
- CCPs differ materially from banks: they do not take deposits, make loans, trade for account, or perform commercial bank roles. These differences limit the applicability of bank resolution toolkits to CCPs and imply potentially faster timeframes for CCP resolution.

### Conflation of recovery and resolution for CCPs
- The FSB’s Guidance emphasizes continuity of essential CCP functions and restoring the CCP as a going concern, which blurs the line between resolution and a second round of recovery.
- For banks, a “lift-out” of uncontaminated critical functions from the wreck is common; for CCPs, catastrophic default loss usually means failure of the risk model, making lift-out “nigh impossible.”
- Without a feasible lift-out, restoring critical functions as a going concern requires correcting the CCP’s balance sheet — an action more akin to recovery than end-of-life resolution.
- The paper argues that treating continuity of critical functions as the primary objective of resolution effectively merges resolution with recovery and may be conceptually problematic.

### Review of policy for CCP resolution — issues examined
- The paper reviews:
  - Whether CCP resolution should aim for full reinstatement as a business.
  - Governance and ownership of CCPs and assignment of responsibility for resolution.
  - The incidence of end-of-waterfall costs (concluding that, under current capital arrangements, CMs must bear end-of-waterfall costs).
  - Loss-allocation mechanisms, notably variation margin gains haircutting (VMGH).
  - The role and applicability of the “No Creditor Worse Off” (NCWO) principle as a normative check in CCP resolution.

*Source: wp1865 - Introduction (IMF Working Paper).*

### conclusion are that taxpayer support might, if CMs’ ability to absorb losses is limited, be

### wp1865 - conclusion are that taxpayer support might, if CMs’ ability to absorb losses is limited, be

### Governance and Stakeholders in CCP Resolution
- Key distinctions vs banks:
  - For banks, capital providers are not users; bondholders and equity owners are expected to take losses; retail depositors protected.
  - For CCPs, which have no retail customers, clearing members (CMs) are expected to bear losses.
- Governance features:
  - CCPs are governed by shareholders (owners) who set prices and have final say on the risk model; risk committees may influence margining and default fund size.
  - Costs of model failure (losses at end of waterfall) are effectively borne by stakeholders other than CCP shareholders under current practice.
- Capital and “skin in the game”:
  - CCPs must ensure owners have a slice of equity at risk, but this stake has been criticized as inappropriately low.
  - Total capital provided by equity investors is limited; parent companies of CCPs are often subsidiaries in infrastructure groups and are unlikely to issue convertible or loss-absorbing instruments in practice.
- Practical constraints on relying on parents/shareholders:
  - Convertible instruments unlikely to have been issued by CCP parents; regulators reluctant to expose other infrastructure entities in the group.
  - Resolving the parent would likely involve too small a financial sum to contain an extreme catastrophic loss that blew out a CCP’s default fund.
- Table 1 (comparison of debt against default fund size of CCPs in large groups) — measures in millions of U.S. dollars:
  - Market capitalization: 12,450  15,180 39,510 6,757
  - Long-term debt: 1,253 19,250 2,231 6,305
  - Default funds of CCP: 7,460 3,479 6,426 2,657
- Conclusion: Shareholders are not the answer under present regulatory capital rules; CMs (or taxpayers) will bear costs in some way.

### Resolution Tools
- General observation:
  - Many proposed “resolution” tools are effectively loss-allocation/recovery tools and may be available as CCP recovery options (VMGH, cash calls).
  - Lift-out approach for banks (removing viable business) does not map cleanly to CCPs because CCPs have no loan book or priority creditors.
- Survey of proposed tools (high-level findings):
  - Bridge CCP: inherits both “bad” and “good” positions; no realistic separation of losses.
  - Sale to competitor CCP: could transfer non-defaulting members’ positions but faces practical issues (balancing the book; readjusting margin/default fund contributions and membership eligibility; sourcing cash to take over loss-making book).
  - Position and loss allocation (write-down/tear-up of contracts): reduces CCP losses by canceling or neutralizing positions but undermines CCP function of ensuring counterparty performance.
  - VMGH (Variation Margin Gains Haircut): appears least unattractive among tools but has moral hazard and other objections.
  - Cash call: legitimate recovery tool; belongs in recovery phase; caps and practical limits on shareholder/CM contributions may render it ineffective by resolution stage.

### Variation Margin Gains Haircut (VMGH)
- Mechanism:
  - CCP withholds on-payment of gains to net gainers while continuing to demand variation margin from losers.
- Advantages:
  - Limited-use VMGH can keep CCP afloat with limited risk to CMs.
  - Provides an additional buffer before taxpayer involvement.
- Empirical scale and context:
  - Largest CCP net open interest positions cited:
    - Eurex Clearing AG: US$1.7 trillion open interest position
    - LCH.Clearnet Limited: US$164 trillion open interest position
    - CME Clearing: US$16 trillion open interest
  - Comparable GDPs:
    - Germany GDP: US$3.4 trillion
    - United Kingdom GDP: US$2.5 trillion
    - U.S. GDP: US$20 trillion
- Risks and objections:
  - VMGH causes losses to market participants (including hedgers).
  - Potential for CM behavior changes that offload VMGH burden to clients.
  - Open-ended VMGH could create moral hazard and force participants to support a CCP despite loss of confidence.
  - VMGH might reinforce price spirals.
- Policy view from the text:
  - Best balance is a single round of haircutting not subject to a financial cap, but additional checks and balances are needed to limit scale and duration and ensure fairness.

### No Creditor Worse Off (NCWO)
- Principle:
  - In bank resolution, tools should leave creditors no worse off than liquidation.
- Application to CCPs:
  - Creditors (CMs) must retain the option to liquidate the CCP; if CMs’ entitlements are unilaterally written down, they lose creditor status and the liquidation option.
  - A robust liquidation option enforces discipline and ensures stakeholders are not forced to perpetually support a failed CCP and its risk model.
- Concern:
  - Liquidation of CCPs is not officially contemplated; absence of liquidation could leave taxpayers as the ultimate backstop, undermining goals to avoid public funds.

### Overview of CCP Resolution — Findings and Implications
- Lift-out approach is generally unworkable for CCPs; remaining options are loss-allocation tools that leave the failed risk model in place.
- CMs or taxpayers will bear the financial burden; CMs may be unwilling or unable to participate in recapitalization in a workable timescale.
- Market structure trends increasing risk concentration:
  - Over a 10-year period to 2015, number of Futures Commission Merchants (FCMs) in the U.S. fell by approximately 60 percent.
  - SwapClear CMs at LCH.Clearnet Limited grew four-fold (over 80 new members) in five years, but the top ten clearing brokers clear 97 percent of the market (top five, 70 percent).
  - Customer assets held by U.S. FCMs grew 45 percent between December 2007 and March 2015.
- Conclusion: A smaller number of CMs is being expected to shoulder a greater volume of risk; it is not obvious that CMs can absorb the potential quantum of loss—raising prospect of taxpayer involvement.
- If recovery fails and insolvency is non-viable, taxpayer bail-out may be the only remaining option.

### IV. A Revised Policy Approach — Key Proposals
A. The Clearing Obligation Should be Relaxed
- Rationale:
  - Mandatory central clearing of OTC derivatives is not always risk-reducing.
- Options proposed:
  - (a) Suspend the clearing obligation in cases of CCP difficulty on a global basis (FSB 2016), allowing bilateral clearing, portability, or other alternatives.
  - (b) Automatically cancel clearing mandate for products where a CM default has blown through the default fund layer for that product and do not reinstate until causes are understood and remedied.
  - (c) Ensure CMs can manage losses (e.g., ability to register offsetting trades); strengthen CCP reserves policies and revise loss waterfall.
- Monetary policy consideration:
  - Implementation of EU regulations on variation margin for uncleared trades was postponed; dealer banks’ balance sheet constraints and collateral transformation dynamics imply that pushing more derivatives to CCPs may build large central bank balance sheets.

B. CCPs Should Widen Sources of Capital, and Build Reserves
- Rationale:
  - CCPs that do not contribute proportionately to default management shift costs to CMs; incentives to clear via CCP vs bilateral clearing are weak or ambiguous.
- Proposals:
  - Encourage CCPs to add further sources of default backing into the waterfall before non-defaulting members’ default fund contributions are used.
  - Consider debt instrument issuance, default insurance, and other sources of default backing to contribute liquidity and loss-absorption capacity.

*wp1865 - conclusion are that taxpayer support might, if CMs’ ability to absorb losses is limited, be*

### Box 4. Should Mandatory Clearing be Relaxed?

### Box 4. Should Mandatory Clearing be Relaxed?

### Netting benefits and CCP fragmentation
- Moving OTC derivatives to CCPs increases multilateral netting—offsetting exposures across all OTC products on SIFIs’ books—which can reduce required margin for a portfolio.
- If there are multiple CCPs that are not linked, the benefits of netting are significantly reduced because across-product netting will not take place, since almost all CCPs presently offer multilateral netting in the same asset class and not across products (Duffie and Zhu, 2009).

### Collateral ambiguity and estimated shortfalls
- There is ambiguity on the amount of collateral posted in the OTC derivatives space; there may be a shortfall of up to US$3–4 trillion (Singh, 2010, 2017).
- ISDA (2017b) sources indicate about US$1.0 trillion of collateral dedicated to the bilateral market (and unrelated to bilateral clearing deficiency, about US$400 billion to the CCP market).
- Financial statements typically capture only variation margin, so these figures may not pick up the full extent of collateral shortfall.
- Collateral is fungible across all pledged collateral lines of a global bank’s business including prime brokerage, repo and securities-lending.
- Using a reuse factor of 2.0, and as CCPs’ rights of re-use of initial margin are curtailed, significant additional collateral will have to be posted to bridge the shortfall.

### Alternative policy: levy on residual derivative liabilities
- Regulations have not mandated reducing residual derivative payables.
- A levy on residual derivative liabilities (i.e., after netting and after whatever collateral is posted) is presented as a more transparent approach than moving OTC derivatives to CCPs, especially if the costs of bailing out CCPs are to be funded by taxpayers.
- If a levy is punitive enough, large banks will strive to minimize their residual derivative liabilities; the primary objective is that large banks minimize these liabilities, which would minimize systemic risk via the OTC derivatives markets if a large bank fails.
- As a by-product of such a levy, residual derivative assets would tend to fall towards zero.

### “Skin in the game,” CCP loss absorption, and reserves
- Official policy underlying the quantification of “skin in the game,” and whether parent companies of CCPs should issue debt capable of bail-in, should be revisited.
- It has been suggested that at present “skin in the game” may not be primarily intended to have a loss-absorbing function. CPMI-IOSCO policy guidance has been interpreted in that sense (JP Morgan, 2017):  
  “[A] CCP should determine and expose an amount of its own financial resources to absorb losses resulting from a participant default [...] [The] amount and characteristics [...] of a CCP’s own contribution to absorb potential losses [...] can enhance confidence among participants with respect to the risk management at the CCP and with respect to the alignment of interests between the CCP and its participants.”
- The responsibility for failed risk models can legitimately be shared more widely than now, implying an enhanced layer of loss-absorbing capital (Carter and Garner, 2015).
- CCPs should be required to develop reserves, and to declare publicly their reserves and dividends policy in relation to the default waterfall.
  - Immediate distribution of profits to shareholders removes a natural buffer which could cushion shocks.
  - CCPs are not obliged by law to develop reserves, though reserves have a useful function as loss-absorbing shareholders’ funds.
  - CCPs that fail to build reserves and then experience defaults involving extreme losses could be required to claw back profits distributed irresponsibly.

### Failed CCPs should be scrutinized
- A CCP whose legally required financial resources prove insufficient has mismanaged its risks.
- Because modeling of risk for margin and default fund sizing is not wholly within CCP control, the causes of a failure may have implications for other CCPs or the clearing of other products.
- The risk aspects of a CCP failure need investigation by a person other than the resolution authority, and the results should be published so lessons can be learned.

### Concluding remarks and policy implications
- Robust infrastructure for clearing financial markets is important for financial stability, particularly where use is mandated by law.
- The amount of financial underpinning is set by law; if misjudged, there should be a simple, predictable, practical plan for what happens when funds run out.
- Present policy on CCP resolution is strongly based on the premise that costs of CCP resolution are borne by CMs or taxpayers; the present risk/reward model for CCPs is unbalanced and resolution policy should not turn the imbalance into distortion.
- The toolkit proposed for resolving CCPs is too closely modeled on tools for failed banks; CCPs are not banks and need a different approach.
- Many proposed tools for resolving CCPs might be unusable in a crisis or even worsen the crisis; additional tools are needed and regulators should accept that the existing policy belief—that mandatory clearing must carry on under all circumstances—may not hold in a crisis.
- The draft EU Regulation attempts to add detail around the FSB’s outline on CCP resolution; CPMI-IOSCO and FSB should modify recommendations so other lawmakers do not assume a bank-style resolution model is suitable for CCPs.
- It is not too late for action to improve policy on failing CCPs.

*Source: Box 4. Should Mandatory Clearing be Relaxed? (excerpt).*

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_Source: https://www.imf.org/-/media/files/publications/wp/2018/wp1865.pdf_