Risk Magazine is reporting a welcome development in the conversation over CCP Loss Allocation. Prominent buy-side firms Blackrock and Citadel have accepted that clients of clearing members, and not just the clearing members themselves, should share the pain in the event of a CCP insolvency. This would help ensure that all market participants are incentivised to behave responsibly and so help preserve the safety and liquidity of the entire system.
This is a welcome, if somewhat overdue, dose of realism. It must surely be fair that all participants share the cost of ensuring the continuity of a CCP, the failure of which would be damaging to all. Variation margin haircutting as a proposal for enhancing CCP resolvability is not new and the fact that it might result in losses being allocated to clients of clearing members, and not simply the clearing members themselves, is well known. It was advocated by the Committee on Payment and Settlement Systems (“CPSS”) and the International Organization of Securities Commission (“IOSCO”) in their July 2012 report on the Recovery and Resolution of Financial Market Infrastructures, by the Bank of England in its April 2013 paper on CCP loss allocation and by ISDA in its August 2013 paper “CCP Loss Allocation at the end of the Waterfall”. It is good to see the initial opposition of some buy-side firms being overcome.
It will be interesting to monitor this conversation – particularly whether it develops to encompass initial margin haircutting – a loss allocation tool which presents difficulties in practical application over and above those associated with variation margin haircutting. The CPSS/IOSCO report sees initial margin haircutting as an effective loss allocation tool which may facilitate access to a much larger pool of assets than variation margin haircutting. However, initial margin haircutting as a loss allocation tool is not supported by ISDA, which believes that it would distort segregation and “bankruptcy remoteness”, have adverse regulatory capital implications and create disincentives for participation in default management processes. For these reasons, initial margin haircutting may be a step too far even for the most enlightened of firms. Nevertheless, as the move towards mandatory clearing continues it is good to see progress being made on this most fundamental of issues.