Broadly, the term ‘financial market infrastructure’ (“FMI”) refers to:
- central counterparties (“CCPs”);
- payment systems;
- central securities depositories;
- securities settlement systems; and
- trade repositories.
FMIs contribute to maintaining and promoting financial stability. However, they also concentrate risk and their disorderly failure could have systemically important consequences. This brings into focus the issues of how to determine the systemic significance of an FMI as well as the design of recovery and resolution (“RRP”) regimes for FMIs that are determined to be systemically important.
Determining Systemic Significance
The key factors in identifying systemic importance in the context of FMIs are generally considered to be:
- inter-connectedness; and
- substitutability of services.
Sometimes a distinction is also drawn between FMI which take credit risk and those that do not. On this basis, non-CCP FMIs such as payment systems are generally regarded as being non-systemic in importance on account of the fact that they tend not to have financial exposure to the same degree as, say, a CCP, and because any failure would likely to be of a more operational or technological nature. In contrast, and particularly in light of the move towards mandatory clearing of OTC derivatives, CCPs are usually regarded as the most important type of FMI, often to the point where their systemic significance is assumed. Given their importance and the fact that CCP resolution requires an understanding of all of the issues which are of relevance to FMI resolution generally, CCP resolution constitutes the main focus of this article.
RRP for Systemically Important FMI
RRP for FMIs can trace its roots back to the G20 Pittsburgh summit in September 2009 in which it was declared that all “systemically important financial firms should develop internationally-consistent firm-specific contingency and resolution plans…to help mitigate the disruption of financial institution failures and reduce moral hazard”. This was followed in October 2011 by the FSB’s “Key Attributes of Effective Resolution Regimes for Financial Institutions” (the “Key Attributes”), which not only set out the core elements considered necessary for effective resolution regimes but also provided sector specific guidance on how these elements apply to FMIs. Subsequently, the high level principles laid down in the Key Attributes were overlaid with more detailed guidance in the CPSS-IOSCO “Principles for Financial Market Infrastructures”, published in April 2012 (the “Principles”) which identified a number of specific recovery measures that FMIs should take. By the time of the G20 Los Cabos Summit in June 2012, RRP for FMI had become a major focus, with the leaders’ declaration providing guidance on the future timetable for financial sector reform in this area. Subsequent work has included the CPSS-IOSCO consultative report on RRP for FMI published on 31 July 2012, followed swiftly on 1 August 2012 by HM Treasury’s consultation document entitled “Financial Sector Resolution: Broadening the Regime”. On 5 Oct 2012 the EU also published a consultation paper on RRP for non-banks and on 17 Oct 2012 HM Treasury published a summary of responses to its August consultation paper.
Viewed in the aggregate it is clear that the overriding concern in designing resolution regimes for FMIs is to maintain continuity of critical FMI functions. In this context, each of the elements detailed within the Key Attributes continues to be relevant, but the following take on a particular level of importance:
- transfer of critical functions; and
- suspension of contractual rights.
It is generally accepted that all FMIs should hold minimum levels of liquid resources, above and beyond those held to cover normal participant defaults, in order to ensure an ability to continue to operate as a going concern. The Principles suggests that this minimum should equate to at least six months of current operating expenses. Nonetheless, losses could, in theory at least, still exceed available financial resources, meaning that some form of statutory bail-in for the purposes of loss allocation (and also recapitalisation), must also be considered.
Traditional bail-in involves the write-down of existing debt and/or its conversion into equity. Unfortunately, unlike banks or investment firms, most CCPs typically do not issue debt securities, limiting the utility of traditional bail-in as a resolution tool. Moreover, whilst loss-allocation mechanisms such as CCP default funds already exist, these arrangements are primarily concerned with loss-allocation rather than recapitalisation. A number of CCP-specific bail-in proposals have been suggested, particularly focused on the ability to apply a haircut to margin. Each has certain advantages and disadvantages, and can result in a very different distribution of losses, as detailed below.
|Haircutting of initial margin
|Haircutting of variation margin
|Enforcing FMI rules to replenish default funds/make cash calls
|Specific clearing member liquidity calls
|Establishment of ex-ante resolution fund
|CCP right to terminate contracts with non-defaulting clearing members for an amount equivalent to that of the defaulter
|Issuance of CoCo bonds by CCPs
A number of industry participants have opposed proposals to allow resolution authorities to impose excess losses on a CCP’s clearing members. It was felt that this would cause uncertainty, potentially lead to distorted incentives such as the early termination and exit of members, result in competitive disadvantage and could have capital and liquidity implications. In light of this opposition, the UK government has recently decided to shelf its plans in this area. Instead, it intends to establish a requirement that loss allocation rules be made mandatory for the purposes of authorisation as a Recognised Clearing House within the UK. However, in general, it seems clear that some form of bail-in for CCPs, probably based on the haircutting of margin, will be the norm, as evidenced by the recent EU consultation paper on RRP for non-banks.
Transfer of Critical Functions
There is a general recognition of the difficulty of successfully applying the business transfer tool to an FMI in general and to a CCP is particular, due, inter alia, to:
- the relative lack of firms which could act as alternative providers of a failed FMI’s critical operations/services;
- the different nature of an FMI’s assets and liabilities;
- operational constraints such as IT system incompatibility;
- competition issues which may flow from ownership structures; and
- national political agendas, such as those currently driving the fragmentation of central clearing of OTC derivatives.
In addition, as the core assets of an FMI (its technical facilities and processes, infrastructure and know-how) do not tend to cause losses in the way a bank’s assets might, it is arguable that they do not merit being transferred to a separate ‘bad’ asset management vehicle under an asset separation tool. All of these factors tend to increase the importance of both bail-in and the bridge institution tools as a method of resolving a failed FMI. This should enable authorities to ensure stability and the continuity of critical services whilst a private sector purchaser is identified, whilst simultaneously avoiding the legal and operational impediments that may arise with an outright transfer to a third party.
Suspension of contractual rights
The ability of resolution authorities to suspend contractual rights is seen as a necessary pre-condition to achieving the transfer, and therefore the continuity, of critical FMI functions. It is recognised that the suspension of payments by an FMI is likely to perpetuate or even amplify systemic risk and could defeat the overriding objective of ensuring continuity of critical operations and services. However, a stay on the termination rights of participants, other counterparties and third party service providers is regarded as an important resolution tool with respect to an FMI, particularly a CCP.
By way of safeguards, the principal of “no creditor worse off than in liquidation” continues to apply. However, with respect to FMIs, this concept should be assessed on the basis of creditor claims as they exist following the FMI’s ex ante rules and procedures for addressing uncovered credit and liquidity needs and the replenishment of financial resources.
RRP for FMI is just one of a number of current initiatives focused on entities that could contribute to the build-up or transmission of systemic risk. These include RRP for insurance companies, domestic systemically important banks (“DSIBs”), investment funds and certain trading venues. However, RRP for FMI is of particular importance given, firstly, the central role played by FMIs (and particularly CCPs) in providing the plumbing for financial markets and, secondly, the emphasis placed on bail-in as a tool in FMI resolution. Bail-in is undoubtedly the most powerful of the resolution tools, capable of delivering immediate and significant results. Unfortunately, the very nature of this power means that, if applied incorrectly, bail-in is just as likely to kill as save. Ultimately, the success of RRP for FMI will lie in striking a delicate balance between the political imperative of ending taxpayer guarantees on the one hand and the economic imperative of securing the financial system on the other. Detailed guidance on the resolution of FMI will begin to emerge in the first half of 2013. At that point, we will have a better understanding of whether the attempts of EMIR and Dodd-Frank to harness the potential of FMIs have merely resulted in the creation of a time bomb which RRP cannot defuse.