31 January 2013

ISDA response to ESMA's Guidelines for establishing consistent, efficient and effective assessments of interoperability arrangements

Clearing Members (“CMs”) do not underestimate the challenges or the risks involved in creating interoperable structures for derivatives clearing. Certainly, the guidelines for interoperability for OTC derivatives CCPs, in particular, will be more complicated than for cash instruments. The difficulties include the potential for systemic risk caused by the CCP which is the weakest link in the chain. Further, the interoperability arrangements for cash equities that currently exist in Europe require additional collateral being posted by CMs to the interoperating CCPs. However, given that the risk profile (including, notably, that OTC derivatives are far less liquid than cash instruments) and settlement periods of OTC derivatives are substantially different to the risk profile and settlement periods for cash instruments3, the required additional collateral appears to be much higher. There are also potential operational complexities for clients that choose the individual segregation model that is required to be offered under EMIR. Individual segregation will add complexities, operational risk and legal considerations within the collateral process between CCPs. For instance, an interoperating CCP would have to potentially maintain accounts for clients of CMs of the other CCP(s).

Despite these and other challenges, the ability of CMs to transfer positions from one CCP to another via CCP interoperability will result in lower liquidity demands and lower individual CCP credit exposures than where interoperability is not in place. Indeed, in the absence of interoperability, active management of swap books on a CCP by CCP basis will be necessary in order to control the amount of collateral the CM will have to provide to each CCP, and their consequent exposure to each CCP. For example, given that the US is characterised by fixed rate mortgages and Europe by pension plan asset-liability management, it is possible that swap dealer participants will be receiving fixed in rates at a US CCP, and paying fixed at an EU CCP. In this case, a balanced rate book for the CM becomes very directional at each CCP, motivating collateral and exposure management, and the provision of higher rate markets for US cleared swaps relative to EU cleared swaps, thus fragmenting the liquidity of the market as it is today.

While again acknowledging the considerable obstacles, the ability for CMs to transfer positions from one CCP to another also appears to be a route to resolve a CCP that is no longer viable and, in so doing, help to mitigate the systemic risk associated with CCP failure.

In light of the above, ESMA standards should be consistent with interoperability while recognising the substantial challenges in realising it. Accordingly, the development of risk management standards necessary will requires at least the following settings:

• Full respect for/adherence to CCP recovery and resolution rules. Derivative CCPs are extremely important to the industry and their smooth operation is essential to the proper functioning of these markets. The arrangements which a CCP makes in respect of recovery are a matter of contract between the CCP and its members. CMs require certainty and transparency in their dealings with CCPs. Accordingly, it is of the utmost importance that these rules are respected by regulators up to the point of nonviability. If resolution is unavoidable, it is imperative that ex ante resolution arrangements are also transparent and predictable.
• Limited liability for CMs to prevent systemic risk. Provision of mutualised resources by guarantors is a risk that cannot be actively controlled, so default fund contributions, assessments, etc, must be a limited and known amount. Should losses ever exceed these defined and known resources, residual amounts must then be shared by all participants, direct and indirect alike, whether through recapitalisation, the closure of segments of a CCP or unpaid variation margin gain haircutting. These measures must be executed in a way which does not contradict the principle of limited liability for CM guarantors, and features such as forced partial tear-ups and uncapped default fund liability should be avoided altogether.
• Protection of, and support for, favourable netting enforceability and collateral arrangements. Interoperability should in no way interfere with CM closeout netting rights or full segregation and bankruptcy remoteness of CM initial margin. In order to report counterparty exposure on a net rather than gross basis, accounting rules require institutions to obtain an unqualified legal opinion that there is a legally enforceable right to net transactions against that counterparty. Put simply, the breaking of netting sets can expose CMs to uncertain risks. Interoperability must be implemented in a way which does not expose CMs to any level of uncertainty with respect to sanctity of CMs’ initial margin or individual CCP netting sets. Further, we urge regulators to cooperate internationally to bring about a robust regime which protects the sanctity of initial margin.
• Mitigation for the risk resulting from different CM requirements. Interoperability for derivatives must address the issue of different CM requirements of CCPs. These differences could result in a weaker, from a risk point of view, CCP causing a cross default in a stronger CCP. There is brief mention in the CP that membership requirement should be monitored (Section 3(2)(d)(i)), but otherwise there is limited consideration given to the issue.
• Flexibility in relation to any interoperability mandate. Sections of the CP suggest that there will be a mandate to accede to interoperability requests and that the only grounds on which a CCP could decline to interoperate is on risk ground (section 2(1)). Given the complexities introduced in this letter, greater flexibility would be needed  derivatives interoperability.

Full document

© ISDA - International Swaps and Derivatives Association