BIS/IOSCO Issue Guidance on Clearinghouse Recovery | Practical Law

BIS/IOSCO Issue Guidance on Clearinghouse Recovery | Practical Law

BIS/IOSCO has released guidance on recovery tools for distressed derivatives clearinghouses, specifying how clearinghouse losses are to be covered and liquidity restored in the event that the viability or financial strength of a systemically important clearinghouse is threatened.

BIS/IOSCO Issue Guidance on Clearinghouse Recovery

Practical Law Legal Update 2-585-1225 (Approx. 4 pages)

BIS/IOSCO Issue Guidance on Clearinghouse Recovery

by Practical Law Finance
Published on 24 Oct 2014 • USA (National/Federal)
BIS/IOSCO has released guidance on recovery tools for distressed derivatives clearinghouses, specifying how clearinghouse losses are to be covered and liquidity restored in the event that the viability or financial strength of a systemically important clearinghouse is threatened.
On October 15, 2014, the Bank for International Settlements (BIS) and International Organization of Securities Commissions (IOSCO) released guidance on the Recovery of Financial Market Infrastructures. The guidance discusses tools that may be used to recapitalize a financial market infrastructure (FMI) and provide liquidity in the event that the FMI's viability or financial strength is threatened. FMIs include clearinghouses, referred to as central clearing counterparties (CCP), which include CFTC-registered derivatives clearing organizations (DCOs).
The report supplements IOSCO's April 2012 Principles for Financial Market Infrastructures (PFMI), and is intended to provide guidance to both FMIs and regulators (see Legal Update, CPSS-IOSCO Principles for Financial Market Infrastructures).
The orderly resolution of FMIs is especially important given mandatory clearing requirements applicable to many swaps under Title VII of the Dodd-Frank Act and non-US regulations such as EMIR in the EU. When a swap or other transaction is cleared, the CCP steps in between the two swap counterparties and executes offsetting mirror transactions with each counterparty, functionally replacing a single bilateral swap with two separate transactions, each between a single counterparty and the CCP (see Practice Note, Mechanics of Derivatives Clearing).
In the event of financial distress, not only can critical functions of the CCP be interrupted, preventing market participants from engaging in required clearing activities, but CCPs may also require a clearing member to help cover losses at the CCP. CCP liquidity or capital shortfall may also be allocated to owners, clearing participants and other creditors.
The guidance discusses tools that may be used to facilitate an FMI's recovery. These include, among others, tools designed to:
  • Allocate uncovered losses caused by the default of a market participant. These include:
  • Address uncovered liquidity shortfalls. These include:
    • obtaining liquidity from third-party institutions; and
    • obtaining liquidity from participants that clear through the CCP.
  • Replenish the CCP's financial resources. These include:
    • cash calls; and
    • recapitalization.
  • Allow a CCP to reestablish a matched book of cleared trades. These include:
    • forced allocation of contracts to certain clearing members or counterparties; and
    • contract termination, including complete, partial or voluntary termination.
  • Allocate losses not related to a participant default. These include:
    • capital and recapitalization;
    • insurance or indemnity agreements; and
    • other tools.
Depending on the jurisdiction, not all of these tools may be available to CCPs. For example, under CFTC's rules, margin posted by a customer in connection with a cleared transaction may generally not be used to cover losses incurred by a CCP due to another clearing customer's default, but certain types of margin may be used to cover a CCP default caused by a general business failure.
On the other hand, under the BIS/IOSCO guidance, general business losses are "properly the responsibility of the owners of the FMI," and should not be offset by clearing member margin accounts. Market participants should therefore examine the policies of the CCP they choose to utilize and the rules of the jurisdictions to which the CCP is subject to determine the risks of clearing at a particular facility.