This is a link to an interesting paper published by the Bank of England relating to CCP loss allocation rules (first spotted over on The OTC Space). The paper explains the reasons why CCPs must maintain a matched book at all times and the process typically followed on the occurrence of a clearing member default. It also provides a useful discussion of the pros and cons associated with various loss-allocation options (particularly around cash calls from clearing members, margin haircutting and contract tear-up) as well as a helpful summary of existing loss-allocation rules of various CCPs, presented in tabular form.
Although it doesn’t provide any answers, the paper does proffer a set of principles, designed to guide CCPs in designing loss-allocation rules. It notes that the Bank of England will have regard to these principles in assessing the suitability of CCPs’ loss-allocation rules. In summary, the principles state that:
- loss-allocation rules should provide a full and comprehensive description of the way in which losses would be allocated – they should be clear, transparent and capable of being implemented quickly;
- tear-up of contracts should be a last resort to prevent the disorderly failure of the CCP;
- where tear-up is used, it should as far as possible be isolated to the affected clearing services so as to limit the risk of contagion;
- loss-allocation rules should positively incentivise participation by clearing members (for example in auctions) and avoid incentives to resign membership (which may prove to be destabilising);
- loss-allocation rules should not disincentivise effective risk management by CCPs, for example by imposing losses solely on participants and not shareholders; and
- loss-allocation rules should not compromise the CCP’s risk management of open positions, for example by ensuring the replacement of initial margin which has been made subject to a haircut.