A key driver to mandate the use of CCPs in the OTC derivatives market is to reduce counterparty risk and systemic risk that arises from bilateral trading relationships. This is achieved by interposing a CCP into any given bilateral OTC transaction. Like other clearing systems or exchanges, the CCP becomes the counterparty to each party to the transaction, which facilitates the reduction of gross exposures through the process of multilateral netting across all participant members in the CCP.
However, mandating the use of CCPs is unlikely to be a simple panacea for market participants. By interposing a CCP into every OTC transaction, default risk is effectively concentrated in the CCP. This then focuses attention on ensuring that the CCP is financially sound and robust with a capital structure that can withstand the failure of a number of its members. Accordingly, it is expected that any proposals made by the Council will include requirements to ensure that any mandated CCP maintains sufficient levels of capital.
This issue has been clearly recognised by the European Commission, which has required the European Banking Authority (“EBA”) to make regulations relating to the capital requirements to be met by CCPs. In this regard, on 6 March 2012, the EBA issued a discussion paper setting out its preliminary views.
The EBA discussion paper concluded that a CCP should hold capital (including retained earnings and reserves) that is at least equal to the higher of:
(a) its operational expenses during an appropriate period for winding down or restructuring its activities; and
(b) the aggregate of the capital requirements for its overall operational risk (for its clearing and non-clearing activities) and its credit, counterparty and market risk relating to its non-clearing activities,
and that these capital requirements should be determined in accordance with regulatory capital standards that apply to banks. The views of the EBA are informative as to the approach that may be adopted by the Council in Australia, which has previously commented that it will seek to achieve consistency (to the maximum extent possible) between the Australian standards and the evolving global standards.
It should be noted that the capital requirements espoused by the EBA relate to the operational or non-settlement activities of the CCP itself. Whereas coverage of credit/counterparty risks that arise as a result of transactions that are cleared through the CCP are intended to be mitigated through the use of posted margin and default funds that are pre-funded by the CCP’s member participants. For example, if a counterparty to a transaction with a CCP defaults, it is intended that the CCP will continue to honour its obligations under “matching” transactions to other counterparties. The CCP will have access to the posted margin and the default funds in order to cover its losses. The posted margin and default fund requirements are likely to form part of the CCP’s “rules”, which will likely need to be approved by the regulators as part of the process of officially mandating a CCP to clear OTC derivatives in Australia.