Capitalisation of bank exposures to central counterparties
Have you ever opened the newspaper or an industry magazine to find yourself faced with acronyms such as CCP, CPSS, IOSCO?
These acronyms might mean nothing to most people, but for those of us working in Capital Markets on specific projects, they should mean something.
A central counterparty (CCP, i.e. Central Counterparty) is a clearing house that interposes itself between counterparties to contracts traded in one or more financial markets, becoming the buyer to every seller and the seller to every buyer and thereby ensuring the future performance of open contracts. A CCP becomes counterparty to trades with market participants through novation, an open offer system, or another legally binding arrangement. For the purposes of the capital framework, a CCP is a financial institution.
CPSS stands for Committee on Payment and Settlement Systems.
IOSCO stands for International Organization of Securities Commissions.
FMI stands for Financial Market Infrastructures.
As we have at least one CCP Project in Hannover and another which is going to start in London, I think it is worth spending some time reading about what we mean when we talk about CCP.
Executive summary[/B] The G20 Leaders, at their Pittsburgh summit in September 2009, agreed to a number of measures to improve the over-the-counter (OTC) derivatives markets, including creating incentives for banks to increase their use of central counterparties (CCPs). The Basel Committee has been working to give effect to the G20 statements, and has developed proposals that require banks to more appropriately capitalise their exposures, while creating incentives for banks to increase their use of CCPs. This includes efforts to ensure that banks’ exposures to CCPs are adequately capitalised.
The Committee also consulted closely with the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO), herein collectively referred to as “CPSS-IOSCO”.
The Committee will continue to rely on the application of the CPSS-IOSCO standards by CCP regulators to determine whether exposures to a given CCP are eligible to receive the beneficial capital treatment.
The Committee still proposes that trade exposures to a qualifying CCP will receive a 2% risk weight, and that default fund exposures to a CCP will be capitalised in accordance with a risk sensitive approach based on the actual financial resources of each CCP and its hypothetical capital requirements.
Overview: OTC derivatives and the role of CCPs OTC derivatives markets have grown considerably in recent years, with the total notional outstanding amounts equal to around US$ 500 trillion at the end of 2010.
Though prior to the crisis both regulators and market participants put in place some actions to strengthen the legal and operational infrastructure for OTC derivatives trading, the crisis exposed fundamental weaknesses.
Then financial markets were in big trouble and market participants faced problems unwinding OTC credit default swaps (CDS).
Moreover, the common practice of counterparties on entering into offsetting contracts was not to close them out but they aroused risk from OTC derivatives exposures and added to the complexity, opacity, and interconnectedness in the financial system. This made it very difficult for market participants, regulators and other relevant authorities to gauge risk exposures and the potential knock-on effects associated with the failure of a major counterparty.
CCPs reducing risk role A CCP interposes itself between two clearing members (CMs) to a bilateral transaction. In particular, the two CMs legally assign their trades to the CCP (usually through “novation”), and the CCP becomes the counterparty to each CM, assuming all the contractual rights and responsibilities.
CCPs can improve the safety and soundness of OTC derivatives markets through the multilateral netting of exposures, the enforcement of robust risk management standards, including mandatory posting of initial margin, and the mutualisation of losses should a clearing member fail.
CCPs provide various safeguards and risk management practices so that the failure of a clearing member will not affect other members.
CCPs can also increase market transparency, as they maintain centralised transaction records, including notional amounts and counterparty identities.
The importance of CCP sound risk management and prudent regulation Despite the benefits that CCPs can bring to OTC derivatives markets, CCPs can concentrate counterparty and operational risks. If these and other risks to which CCPs are exposed are not well managed, a CCP presents systemic risk that arises from its own potential failure.
Standards for the supervision and oversight of financial market infrastructures, including CCPs, are the responsibility of the CPSS-IOSCO.
Overview of the CCP framework This framework will apply to all exposures to CCPs arising as a result of financial derivatives (i.e. OTC and exchange traded derivatives), repos/reverse repos and securities lending and borrowing transactions.
When entering into bilateral OTC derivative transactions, banks are required to hold capital to protect against the risk that the counterparty defaults and for credit valuation adjustment (CVA) risk.
The CVA charge was introduced as part of the Basel III framework.
This new framework for capitalising exposures to a CCP is relying on new Principles demanded by CPSS-IOSCO about FMIs where the aim is to improve robustness of financial markets by having enhanced infrastructures.
If a CCP complies with these Principles (it will be called Qualifying CCP, i.e. QCCP), exposures to such CCPs will receive a preferential treatment as compared to exposures to CCPs that do not comply.
Please read the article in the attached pdf for all further details about proposed CCP framework.