Baroness Kramer
Main Page: Baroness Kramer (Liberal Democrat - Life peer)Financial Stability: Central Counterparties
Baroness Kramer Excerpts
Baroness Kramer
To ask Her Majesty’s Government what assessment they have made of the possible threat to financial stability from the risks concentrated in Central Counterparties.
Baroness Kramer (LD)
My Lords, I have sought this debate in order to understand from the Government their assessment of central counterparties, the extent to which CCPs mitigate risk, but also the extent to which their inherent character of concentrating risk can in itself amplify financial instability.
A CCP is an entity that interposes itself between counterparties to contracts traded in financial markets, becoming the buyer to every seller and the seller to every buyer and thereby guaranteeing the performance of open contracts. In a sense CCPs act as a firewall, enabling multilateral netting among clearing participants, reducing credit exposure, offering operating efficiency and also providing anonymity, which some believe increases liquidity in the system. At the moment a transaction is initiated, the CCP has no market risk—the book is matched. But prices change rapidly and constantly and CCPs cover such exposures primarily by requiring collateral. I shall say more about collateral in a moment.
The primary use of CCPs is to clear derivatives contracts and one of the reforms by regulators following the financial crash of 2007-09 was to make the use of CCPs mandatory for the clearance of standard over-the-counter derivatives. I fully recognise that this has brought transparency and some order to an opaque and chaotic system and offers greater protection to counterparties. The last financial crisis was far worse because no one knew to whom anyone had exposure.
However, by definition, the concentration of risk within a CCP is itself a systemic risk. The daily global exposure in CCPs is estimated to be in the trillions of dollars but no exact tracking is available. Default potentially affects not only national but international financial stability. CCPs are linked by an extensive cross membership; the major global banks belong to virtually every CCP. Interoperability arrangements between CCPs enable members of one to clear transactions without opening accounts in the other. CCPs are often part of a larger financial group, and firewalls between group members are not necessarily complete. According to the Bank for International Settlements in its quarterly review this December, this growing interconnectedness raises the question of whether CCPs might spread losses in the case of defaults or intensify deleveraging pressures in ways that add to systemic risk.
As for the UK, the Bank of England, which took over supervision from the FSA in 2013, supervises some of the largest global players, including LCH. Clearnet Group and ICE Clear Europe, while a number of major and minor CCPs incorporated overseas also operate in the UK. Our exposure is multicurrency and so requires the Bank in extremis to be able to access liquidity in other currencies, especially the euro. It is part of our global financial services industry rather than support to our domestic economy.
This House discussed CCPs and the risk they present in the debates on the Financial Services Act 2010. During that debate the Government took the position that default risk could be contained by a risk waterfall of cascading lines of defence. The first line of defence is collateral, required through both initial and variation margin calls. However, the noble Lord, Lord Sharkey, and I, in 2012, raised questions both about the inherent quality of collateral and the competitive pressures on CCPs to take a more lenient view of both collateral quality and margin requirements. There is not enough high-quality collateral in the globe to meet the margin requirements of CCPs. Therefore lower-quality collateral is improved by being bundled and then given a haircut—that is, discounted. This may remind your Lordships of some of the financial instruments implicated in the 2007-09 crash: it is susceptible to abuse. CCPs around the globe compete fiercely and there is always a risk that this can lead them to compromise the quality and levels of collateral.
The collateral demands of CCPs will, by definition, move with, not counter to, an economic cycle. This means that both initial and margin calls increase the volatility of prices of collateral, such as sovereign bonds, which in itself can amplify financial instability. CCPs hold vast amounts of their collateral in major banks. As we know, no major bank is ever totally safe from failure and so another risk is added. This risk increases because many clients, to reduce their costs, permit the CCPs to on-lend or invest the collateral. At present, these collateral-related issues are not transparent. Are the Government attempting to remove the mask not only domestically but globally?
If collateral is insufficient, the second line of defence is a cascade of reserve or guarantee funds contributed or committed by members of the CCP as a condition of their membership. Your Lordships will understand that these are thinly capitalised entities. The cascade varies by jurisdiction but essentially begins by tapping the defaulting member and, if that is insufficient, calling on the other members of the group. In the Financial Services Act 2012, the Government allowed members’ exposure to such mandatory contributions to be strictly limited—not unreasonable—on the assumption that no member could survive with unlimited liability. However, we do not know how sufficient the barriers really are. CCPs in the UK are also required to put in place recovery and resolution plans to protect the taxpayer in the event of failure. Can the Government tell us how advanced these plans are?
I am sure the Government would agree that, with so many questions and given the consequences of a failure, stress tests for CCPs are crucial. Will there be transparency around such stress tests? Will the criteria and performance results be public? Since a failure in one jurisdiction can so easily contaminate another, can we be assured of a global standard of risk protection and co-operation among regulators?
While I have raised the risks of CCPs, I recognise that there are significant risks in the non-standard transactions, especially the non-standard derivatives transactions, that sit outside them. Is the regulator succeeding in persuading the industry to deconstruct complex trades so that they can be cleared on the CCPs? I realise that the regulators are requiring banks to hold additional capital for unclear trades, but many of the players are commodity companies, especially oil companies, and these are just as capable of infecting the system. Additionally, these non-standard trades are increasingly taking place in dark pools. Are we sure that enough is happening in the light both for proper risk management and for proper price discovery to take place?
We are also in an era where we begin to see the disintermediation of the traditional financial service players. Block chain will in effect dislodge all the current post-trade architecture and may well eliminate CCPs altogether, but block chain raises issues of its own. Transparency is particularly important in block chain, but we cannot see, for example, what is happening in a vital market like China—the great firewall of China, as I understand the industry calls it. That surely is untenable. While block chain has the potential greatly to reduce risk, its key feature, which is the dispersal of data, raises serious new jurisdictional issues. Who is in charge in a crisis? Will the Government update us on how they are addressing the development of block chain and the trading architecture, how they view the associated issues and how they are considering the transition from the current architecture to the new?
The inconvenient truth is that in a major financial crisis, if two or three major banks were to fail, all the defences offered by CCPs would be overwhelmed, rather like the flood defences in Cumbria this week. We need to know how high the financial flood walls are. I look forward to hearing much more from the Government on stress tests, on transparency and on recovery and resolution plans. I hope that in this debate, the Government will answer our questions on CCP governance, collateral quality, capacity for loss absorbency, potential for contagion and international co-operation. There is a danger that CCPs are a two-edged sword, dampening risk in modest crises but amplifying risks in high crises.
Lord Ashton of Hyde (Con)
My Lords, I think I shall have to talk quickly. I, too, thank the noble Baroness, Lady Kramer, for securing this debate and other noble Lords who contributed. It has been an important and rather select debate on a fairly technical subject. That being so, I will try to pick up a number of points made by noble Lords, but if I do not cover them I will check to see whether I need to write with a more comprehensive answer. In particular, I might have to write to the noble Lord, Lord Sharkey, on some of his points.
As today’s discussion has highlighted, central counterparties, or CCPs, are critical parts of the financial infrastructure. Their purpose is to stand between the counterparties trading a financial instrument, guaranteeing that if one of those counterparties defaults on its obligations, the other will receive what it is due. They perform the function of a firewall, preventing contagion and increasing market confidence. They are more important than they have ever been, as has been noted. In 2009, the G20 agreed to mandate the use of CCPs in over-the-counter derivatives as appropriate. Fifty per cent of the global over-the-counter interest rate derivatives market—the largest segment of the OTC derivatives market—is now cleared through CCPs.
This is one of the key post-crisis reforms, which the Government fully supports. Its implication, as noble Lords have recognised, is that CCPs are increasingly systemically important. Therefore, I would like to set out the steps that have been taken here in the UK to ensure their resilience and that—in the unlikely event of a CCP’s failure—the authorities have the powers to step in to minimise the impact on financial stability.
As noble Lords will be aware, the coalition Government acted as soon as they came into office to overhaul the UK’s regulatory architecture, and a key part of this was to put the Bank of England in charge of the supervision of financial market infrastructures, including CCPs. The Bank of England has met this new responsibility by creating a special financial market infrastructures directorate that reports directly to the deputy governor for financial stability, and a dedicated decision-making committee. The FMI function reports annually to Parliament on its work.
In supervising CCPs, the Bank holds them to exacting requirements that are consistent with international standards, as implemented in the EU through the European Market Infrastructure Regulation. Each CCP must collect sufficient collateral from each user to ensure that if that user defaults the CCP has ready funding to cover its obligations to its counterparties. Over and above this, CCPs must maintain a pre-funded “default fund” to cover any losses due to a defaulting user which are not covered by the collateral that has been posted to the CCP by that user. They must hold enough own-capital, collateral and default fund assets to enable the CCP to withstand, under,
“extreme but plausible market conditions”,
the simultaneous default of the two users to which it is most heavily exposed.
That is already a tough requirement yet, as UK regulation requires, all UK CCPs go significantly further than this and have in place rules which ensure that if the default fund were ever exhausted, the CCP could require its users to make substantial cash contributions to ensure that the CCP continues to perform an uninterrupted service. A raft of other requirements covers CCPs’ risk management, operational capital, governance, liquidity and other arrangements. Noble Lords should understand that CCPs are regulated in this country to strict standards designed to ensure that they are highly resilient. For example, when Lehman Brothers failed, it went through only 35% of the margin held by its biggest CCP.
The chances of a CCP failure are reduced still further by the significant capital and other reforms that have been enacted here and elsewhere to enhance the robustness of global banks and to develop arrangements to resolve failed banks, the CCPs’ biggest users, in a way that avoids them defaulting on their obligations to a CCP.
However, it is, of course, not theoretically impossible that a CCP could fail and it is essential that the Government are prepared. For this reason, in 2012 the Government passed legislation to ensure that the Bank of England can intervene to resolve a failing CCP in a way similar to how it can intervene to resolve a failing bank by transferring a CCP or its property to either a private sector purchaser, a bridge CCP owned by the Bank of England or any other person. The UK moved ahead of the rest of the world in introducing this legislation. In answer to the question asked by the noble Lord, Lord Tunnicliffe, international work is seeking to ensure that the necessary powers and standards in this area are enhanced and adopted globally. The Government and the Bank of England are playing a leading role in these discussions at EU level, in the Financial Stability Board, of which the governor, Mark Carney, is the chairman, and through the CPMI-IOSCO group of global regulators. The EU Commission itself is represented on the relevant groups in the FSB.
International standards on recovery and resolution are critical to prevent UK banks being exposed when using overseas CCPs and to ensure a level international playing field for CCPs. There is also further work taking place in the areas of stress testing of financial resources, margin requirements, which I will say a bit about later in answer to the question asked by the noble Baroness, Lady Kramer, and liquidity requirements to enhance CCP resilience further.
Given London’s leadership in this area—we have globally significant CCPs here, such as LCH.Clearnet Ltd and ICE Clear Europe—noble Lords will understand that it is essential that these standards are developed in co-ordination with the other major jurisdictions to ensure that CCPs in the EU are not put at a competitive disadvantage to those located elsewhere. This is a key priority for the Government going forward.
The noble Baroness, Lady Kramer, asked about recovery and resolution on CCPs. UK CCPs are required to produce recovery plans. In addition, the UK has a resolution regime for CCPs allowing the Bank of England to transfer some or all of the business of a CCP to a private purchaser, as I mentioned, and to transfer ownership of the CCP to another person.
As far as international developments are concerned, in October 2014 international central banks and regulators published guidelines on CCP recovery and resolution: the CPMI-IOSCO report Recovery of Financial Market Infrastructures and the annexe on FMI resolution in the Financial Stability Board’s Key Attributes of Effective Resolution Regimes for Financial Institutions. The European Commission continues to work on the legislative proposal regarding CCP recovery and resolution, which has not yet been published. This will supplement the resolution tools already available to the Bank under the UK resolution regime.
The noble Baroness also asked about stress testing. In October, the Bank of England said that it is considering explicitly including CCPs in its wider stress testing of the financial system over the medium term. She mentioned dark pools, which are something that the Bank of England is thinking about. Previously, non-standardised OTC derivatives presented a significant potential risk to the financial system due to the leverage risk exposures they presented to market counterparties and to their opacity. International standards have been developed and are being implemented that require counterparties to derivative trades that are not subject to central clearing to exchange margin to cover those exposures. Uncleared derivative exposures are also considered in the higher capital leverage requirements European banks will be required to meet. With regard to the transparency of these products, all derivatives trades by EU counterparties have to be reported to regulated trade repositories.
As far as the use of block chain, which is an interesting new development, this distributed ledger technology may represent a change in how payment systems work—indeed, it does represent a change in how payment systems work—but the use of this technology is currently very small. The Bank of England as supervisor of payment systems would continue to monitor its application.
On risk of contagion and greater price volatility from CCPs’ actions, are the scale of risks and extent understood? Banks are now far more resilient and both they and their supervisors will assess the risk against the CCP, exercising its assessment rights in full. As far as price volatility is concerned, international policy developments on recovery and resolution in particular are considering the adequacy of tools, including the impact of these tools on clearing members and clients.
The noble Lord, Lord Sharkey, asked what progress we are making on reducing interconnectedness between CCPs. Of course the whole point is that they are interconnected, so the Financial Stability Board, a global body, is undertaking work on interconnectedness and how these risks may be mitigated. The FSB will report by the end of 2016.
The noble Lords, Lord Tunnicliffe and Lord Sharkey, asked whether there was sufficient co-ordination on international standards for CCPs. We think co-ordination at an international level is working well, which is obviously very important. It is important for both financial stability purposes and for the competitiveness of the EU that CCPs are able to operate on an international level playing field.
The noble Lord, Lord Tunnicliffe, asked about the Senior Managers and Certification Regime, which we are hoping to apply in the Bank of England Bill. This will not apply to CCPs because these bodies are not authorised persons under the Financial Services and Markets Act. They have always been subjected to a specialist regime. The SMCR will not apply to them, but governance is a key focus of the Bank of England in its supervision of CCPs to ensure that commercial objectives are not inappropriately prioritised over systemic risk management, building on the PRA’s work during 2014 on governance, banks and insurers. The Bank of England does have the right powers to hold CCP senior managers to account.
Lastly—I am running out of time—do we think that the concept of “too big to fail” applies to CCPs? Well, they can clearly be systemic. This is not only due to the significant exposures, but more importantly because of their critical role in the operation of markets. That is why we have introduced legislation to establish a resolution framework for CCPs, and why we support the international and EU reforms to enhance the resilience of CCPs.
I apologise for not answering all the different questions, and I will definitely write to all noble Lords who have participated. I would like to thank again the noble Baroness, Lady Kramer, for securing this debate. I hope that I have shown in the limited time available that we do have a robust regime in place, but that the Bank and the Government are not complacent and are still working to develop national and international standards.
Baroness Kramer
My Lords, I would like thank all the Members who took part in this—my noble friend Lord Sharkey and the noble Lord, Lord Tunnicliffe—and to say to the Minister that we appreciate the efforts that he made to respond and look forward to the further Written Answers.