Global

Details

  • Industry: Financial Services
  • Type: Regulatory update
  • Date: 7/22/2014

Passing the buck 

Resolution planning continues to expand in scope. First the globally systemically important banks, then all credit institutions and major investment firms – that are within the scope of the BRRD, next the globally systemic insurers, and now the potential to add asset managers if their failure would have a systemic impact. However, another, less publicised, area of resolution planning is already having an impact on the risk appetite of all buy-side and sell-side users of centrally cleared OTC derivatives.

Later this year the FSB will finalise how their Key Attributes should be applied to the recovery and resolution of Financial Markets Infrastructure (FMI). This will be closely followed in Q4 with the European Commission consultation on resolution regimes for FMI. However, a quick glance at recent developments in the UK may provide an indication of the ultimate direction of travel.

In June 2014, the UK's amended Financial Services and Markets Act 2000 came into force to ensure that a central clearing house (CCP) can continue to operate when its solvency is threatened, not due to a clearing member default, but because of investment or operational loses. This required the UK CCPs to change their rules to allow such losses to be mutualised amongst clearing members.

For many clearing members who are already seeing reduced levels of profitability and increased regulatory capital requirements, this may act as a catalyst to revise current pricing strategies and/or explore ways in which to pass on such potential losses to their underlying clients. There are already reports of some broker/dealers reviewing their existing agreements to determine whether investment losses can technically be passed onto clients. If not, then end users could find the cost of dealing in derivatives increase as CCPs try to cushion themselves against any future failure.

Either way, it will likely be the end users of OTC derivatives, many of whom are themselves regulated firms that need to develop their own resolution plans that will bear the costs. However, it is unclear whether they are aware of this potential risk and resultant costs to their own business should a CCP collapse, and we have seen little evidence so far that the impact is being considered.

Banks, asset managers, insurers and pension funds that deal in OTC derivatives (whether as buyers or sellers) need to assess the potential impact on their business (and the risks to their customers) and determine their response. Those responses will not only depend on the actions taken by CCPs, but also on the volume of OTC derivatives undertaken. For some, this may be a simple re-examination of the economics of derivative protection due to increased costs of trading. However for those undertaking a significant amount of OTC derivative trading, this will require a more thorough assessment, including re-assessing their operational risk appetite and determining whether they can or should be taking steps to mitigate potential losses from centralised clearing. All financial sector firms should also consider whether any of their own proposed responses to stress events rely on derivative solutions, and the impact that a CCP collapse could have on the availability of these at the time they are most required.

As the volume of centrally cleared OTC derivatives grows it may also be worth speculating whether a buy-side firm would ever want or could become a direct clearing member in the future.

For more information, please contact:

Andrew Davidson

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