Responding to a CFTC request for comment on whether establishing a capital threshold on participants is an effective approach to promoting fair and open access to derivatives clearing organizations, the UK Financial Services Authority said that, while capital thresholds for such organizations may be a potential tool to help ensure fair and open access to central counterparties, to impose them on clearing arrangements for products that have complex or unique characteristics could lead to increased systemic risk. In a letter to the CFTC, FSA Director of Markets Alexander Justham emphasized that participation requirements sometimes need to be tailored to take into account the types of products being cleared by a central counterparty.
For example, the less liquid derivative markets typically require more complex default management processes that impose more onerous obligations on the participants than the exchange traded futures market. The ability of the surviving clearing members to meet their obligations in relation to default management is important in mitigating systemic risk in the event of a clearing member default.
Generally, Director Justham reaffirmed the FSA’s support for the clearing of standardized derivatives contracts through central counterparties. Regulators need to consider how existing market infrastructures can best play a role in meeting these commitments in an environment where central counterparties are becoming increasingly systemically important.
He said that there is a clear need for stronger international standards for central counterparties. In that regard, the FSA is contributing to the work currently underway on developing such standards through the Committee on Payment and Settlement Systems-IOSCO consultation on principles for financial market infrastructure.
The FSA supports transparent and non-discriminatory rules, based on objective criteria, governing access to central counterparties. The Director noted the CPSS-IOSCO principle that central counterparties should allow fair and open access to their services based on reasonable risk-related participation requirements.
Risk management standards for central counterparties must be anchored in the characteristics of the products being cleared, he said, and the FSA recognizes that different product types may require different clearing models. This can extend to participant eligibility in models where the clearing members are required to perform specific actions to assist in a member default, such as interest rate swap clearing models that include an obligation to bid for portfolios from the defaulting clearing member.
As noted by CPSS-IOSCO in its consultation, a central counterparty should ensure that its participants have the requisite operational capacity, financial resources, legal powers, and risk management expertise so that their activities do not generate unacceptable risk for the central counterparty and other participants. Capital requirements, the swap dealer criteria and portfolio size or volumes have previously served as proxies for establishing that a clearing member meets these criteria. If such criteria are to be excluded from regulations, noted the Director, then central counterparties must develop alternative membership criteria that ensure their own safety. Consideration should be given to the time required to develop such criteria.
Central counterparties must set appropriate risk based membership criteria that test a clearing member’s financial and operational ability to manage the default of one of their own clients through hedging or liquidating positions. They must participate in the default management process without introducing risk to the system, and hedge any portfolios acquired in a default auction, or manage any risks presented by the forced allocation of a portfolio in a default process.
Potential clearing members who lack the requisite operational capacity, financial resources, legal powers or risk-management expertise to participate in a default management process might consider sourcing these capabilities to a more experienced third party in the event of a default. But the Director warned that outsourcing the clearing member responsibility to partake in the default management process to a third party could present additional risk to the system and increase the cost for the participant.
A central counterparty may seek to reduce the relative impact of the default process on participants with lesser financial and operational ability by providing that their role in a default be proportional to the risk they introduce. As this would only limit the relative and not the absolute size of the risk, for example the size of portfolio that could be allocated to a clearing member in a default, this approach does not reduce the central counterparty’s need to set the appropriate membership criteria needed to gauge the ability of the clearing member to engage fully in the default management process.
The senior official noted that the Commission proposes that central counterparties may exclude or limit certain types of market participant if they can demonstrate that the restriction is necessary to address credit risk or deficiencies in the participants’ operational capabilities that would prevent them from fulfilling their obligations as clearing members.
If capital requirements, the swap dealer criteria and portfolio size or volumes are to be subject to limitation as criteria, then the FSA believes that the Commission’s exclusion should specifically extend to address clearing members whose operational capabilities would prevent them from fulfilling their obligations to the central counterparties to participate in a default management process. The FSA therefore requests that the final CFTC rules take into account that access should be based on proportionate risk-related participation requirements and that risks may be introduced into the system by universally prohibiting certain participant eligibility criteria.