The Clearing Corporation of India Limited Risk Management Department Consultation Paper. Recovery tools at the end of the prefunded Default Waterfall

Transcription

1 14 th Feb 17 The Clearing Corporation of India Limited Risk Management Department Consultation Paper Recovery tools at the end of the prefunded Default Waterfall 1.0 Introduction 1.1 CCIL maintains prefunded resources in all the clearing segments to cover potential losses arising from member default. The sequence in which the above resources (along with the margins contributed by defaulting member) are used is known as the Default Waterfall. 1.2 As per this waterfall mechanism, after the defaulter s margins and the defaulter s contribution to the default fund have been appropriated, CCIL s contribution from the settlement reserve fund (SRF) [known as CCIL s Skin in the Game (SIG) ] is used to meet the losses arising out of member default. Post utilization of CCIL s SIG if there is a residual loss, the same is appropriated from the default fund contributions of surviving members. 1.3 CCIL has created a Settlement Reserve Fund (SRF) to meet losses from participants default and also for losses other than participant default, viz. Settlement bank risk, investment risk, custody risk and other operational risks. The current balance in the fund is Rs crores. CCIL has a board approved process to facilitate replenishment of the SRF in case of its depletion. Such replenishment will be done by transfers to the SRF from the General Reserves of the Company. 1.4 Currently, CCIL s contribution to meet losses on a member default is capped (segment wise) at a specific percentage of the balance in SRF. CCIL has proposed in its recently issued consultation paper that CCIL s SIG will be sized at 25% of the member contributed default fund of a segment. CCIL s SIG will be split into 2 tranches, viz. tranche 1 (15% of member contributed default fund) to be used before default fund contributions of surviving members are used, and tranche 2 (10% of member contributed default fund) to be resorted to after default fund contributions of surviving members are used but before calling for further 1

2 contributions from them. In addition, CCIL will also ensure that its SIG is at least equal to the highest amount contributed by any member in each segmental default fund. 1.5 The quantum of the Member contributed Default Fund for each clearing segment is equal to the highest stress loss (in the last 6 months) of any entity and its affiliates along with stress loss of 5 weak entities in the clearing segment. The adequacy of the prefunded default resources (member contributed default fund plus CCIL s SIG) is assessed as part of the credit stress tests conducted by CCIL every day. 1.6 If the pre funded default fund resources are exhausted, CCIL has the right to call for additional contributions from non defaulting members to not only replenish the default fund but also contribute towards the uncovered residual loss if any. 1.7 In the sections below, we mention how the additional contributions from members (as mentioned in 1.6 above) will be used to replenish the default fund and help CCIL in offloading defaulter s portfolio through auctions to the extent possible. We also propose additional recovery tools, viz. forced allocation and selective tear up that will be employed if there is a residual portfolio of the defaulter post auctions. 2.0 Need for Recovery tools 2.1 In an extremely rare but plausible scenario, there is a possibility of an unprecedented movement in market prices/ rates such that the losses on a defaulter s portfolio are significantly higher than the coverage provided by the prefunded resources. Recovery tools are required to deal with the adversities of such disruptive situations comprehensively. 2.2 CPMI IOSCO (Oct 2014) report titled Recovery of financial market infrastructures states that the following characteristics help to evaluate the strengths and weaknesses of tools in order to choose the set of tools that is most appropriate for each relevant recovery scenario: i. Comprehensive ii. Effective iii. Transparent, measurable, manageable and controllable iv. Create appropriate incentives 2

3 v. Minimise negative impact 2.3 The report states that FMI should endeavour to develop a set of tools, including the sequence in which they would be used, that exhibits these characteristics to the greatest extent possible. However, because no set of tools may fully satisfy all the characteristics, an FMI will need to determine which set achieves the best trade off. 2.4 The report mentions that all systemically important FMIs should have a comprehensive and effective recovery plan, because the disorderly failure of an FMI can lead to severe systemic disruptions. The report defines Recovery as the ability of an FMI to recover from a threat to its viability and financial strength so that it can continue to provide its critical services without requiring the use of resolution powers by authorities. 2.5 Having in place a well defined recovery plan with recovery tools has two benefits. First, losses are allocated in a comparatively quick, orderly and transparent manner determined by the CCP and its members. Second, by having a well defined recovery plan in place, a CCP would be able to continue operating without disruption to the market it clears. 2.6 The recovery tools proposed in this document are designed to manage the following scenarios: a) To allocate uncovered losses caused by participant default b) To replenish financial resources c) To re-establish a matched book following participant default 3.0 Proposal 3.1 Recovery tools for Forex Forwards and Derivative Segments of CCIL CCIL currently offers clearing in two derivative segments, viz. Forex forwards and Rupee derivatives. A default waterfall with prefunded resources is in place in these segments where losses arising from default will be allocated in the under-noted sequence: Defaulter s margin contribution Defaulter s contribution to the default fund 25% of balance in CCIL s Settlement Reserve Fund (SRF) 3

4 Default fund contributions from non defaulting members If the pre funded default fund contributions from non defaulting members is exhausted, CCIL has the right to call for additional contributions from such members. The same is detailed under provisions of sub-section (J) of Chapter VII of Regulations for Forex Forwards Segment and under provisions of sub-section (J) of Chapter IX of Regulations for Rupee Derivatives Segment. In the sections below, we mention how the additional contributions from members will be used to replenish the default fund and help in offloading defaulter s portfolio through auctions. We also propose the following recovery tools, viz. forced allocation and selective tear up that will be employed if there is a residual portfolio of defaulter post auctions Auction (first round) with pre funded resources 1. Auction of the defaulter s positions is the first step in the Recovery process. Incidentally, Auction model for default handling in derivatives segments was finalized after extensive member consultations and is expected to be formally implemented after the necessary regulatory approvals are in place. 2. The defaulter s portfolio will be auctioned among non defaulting members. Bidders in the auction will require to be paid (at least) the MTM loss (computed based on CCIL s MTM price on the day prior to auction date) of the defaulter s portfolio since the default announcement. However, markets may be stressed during a large scale default, and non defaulters may not be keen to pick up defaulter s portfolio, due to illiquidity of some of the defaulter s positions. Therefore, some slippage from the MTM value of the portfolio may be required to arrive at the reserve price for the auction to provide incentive to bidders. 3. Preventing collusion in bidding behaviour is important to ensure that the process is fair and equitable. Hence, a Discriminatory Price, Sealed Bid auction will be conducted with available pre funded resources. 4. Default Management Committee (DMC) will determine the reserve price for the auction. However, CCIL will have the right not to accept the reserve price set by the DMC 4

5 in case it feels that the reserve price set by the DMC does not serve the interest of the system as a whole. CCIL will in such circumstances present its argument in writing to the regulator explaining why it did not accept DMC s recommendations. 5. Defaulter s positions will be offloaded to bidders in the order of their bid prices with available resources. 6. The auction is likely to be successful if competitive bids are received for the entire portfolio and the resources required for acceptance of all winning bids is less than the prefunded resources of CCIL. The same is most likely to happen if the MTM loss on the defaulter s portfolio is less than the prefunded resources of CCIL. 7. However, if MTM loss on the defaulter s portfolio exceeds prefunded resources, only a portion of the defaulter s portfolio is likely to get offloaded to winning bidders in this auction. The residual positions of the defaulter will be offloaded through subsequent steps as discussed below Cash call in proportion to default fund contributions 1. DMC will determine the reserve price applicable for second auction. MTM price at the end of the day of first auction will be used as the basis to arrive at reserve price that will be used to call for additional resources from all members. Such resources from members will be utilized to offload defaulter s residual portfolio to winning bidders in the second auction. Members also have the obligation to replenish the default fund. 2. As per CCIL Regulations for derivatives clearing segments, viz. Forex forward and Rupee Derivative segments, non defaulting members who are active in the segment have obligations to meet loss allocation assessment and default fund replenishment together if defaulting member s loss exceeds prefunded resources. 3. The cash call amounts from members will be in proportion to their default fund contributions (excluding defaulter s contributions to the default fund). Members who do not meet their obligations in meeting allocation assessment will not be allowed to participate in the second auction. 5

6 4. CPMI IOSCO report mentions that 1 : If the cash call is in proportion to the default fund contributions, then to the extent that default fund contributions proxy the risk brought by participants to the FMI, the assessment right would provide ex ante incentives for participants to limit the risks that they bring to the FMI Auction (second round) with contributed resources 1. A second auction will be held with members resources contributed in response to cash calls [as discussed in (3.1.5) above]. The auction design will be the same as the first auction i.e. Discriminatory Price, Sealed Bid auction will be conducted. 2. The auction is likely to be successful if resources required for acceptance of winning bids is less than the contributed resources from members and winning bidders in the second auction pick up the entire residual portfolio of the defaulter. 3. However, if the MTM loss on the defaulter s residual portfolio exceeds the resources contributed by members, only a portion of the defaulter s portfolio is likely to get offloaded to winning bidders in this auction. The residual positions of the defaulter will be offloaded through subsequent steps as discussed below Forced allocation of residual positions of the defaulter to non defaulters 1. CPMI IOSCO Recovery Report mentions that to address the likelihood that voluntary methods might prove insufficient to re establish a matched book, a CCP will need to have a mandatory, ex ante agreed mechanism to do so, such as forced allocation or termination of contracts. Even though such tools carry potentially severe drawbacks and risks, CCP should identify in its rules which mandatory tool(s) it would use to re establish a fully matched book should voluntary mechanisms fail to do so. 2. If there are no resources left after the second round of auction, the residual positions of the defaulter will be forced allocated to the members who did not respond to cash calls. The forced allocated amounts will be in proportion to member s defaulted cash call amount. 1 Ref of Recovery of financial market infrastructures (Oct 2014) [CPMI IOSCO]) 6

7 3. If there are some resources left after the second round of auction, the residual positions of the defaulter will be forced allocated to those members also who responded to cash calls but did not bid competitively in the second round of auction. The compensation to these members will be in proportion to the positions allocated to them and to the extent resources are available. No compensation will be paid to members who did not contribute to cash call and got forced allocated. 4. Members having opposite positions to that of the positions being allocated will have their portfolio effectively torn up. 5. Because of the structure as mentioned in (2) and (3) above, members would be incentivized to respond to cash calls as they know, ex ante, that not responding to cash calls is likely to increase the chances of unsuccessful auction of defaulter s portfolio thereby increasing the chances of forced allocation Tear up of all positions of members who failed to honor the margin obligations on account of forced allocation 1. There is an extreme but plausible scenario of a member(s) not meeting their margin obligations due to forced allocation of defaulter s portfolio. 2. If such a scenario does happen, the members who failed to make their margin payments will have all their positions torn up with members having opposite positions on a pro rata basis. 3. The resources available in the margin account of members who fail to meet the margin obligations will be used to compensate the counterparties (to the extent of their reduction in MTM gain) whose positions would be torn up. In case the resources in the margin account are insufficient, the same will be paid to members on a pro rata basis. 7

8 3.2 Recovery tools in Cash Segments of CCIL The cash segments where CCIL offers clearing services are as follows: Securities segment CBLO segment Forex (USDINR) settlement segment A default waterfall with prefunded resources is in place in all the above mentioned segments where uncovered credit losses will be allocated in the under-noted sequence: Defaulter s margin contribution Defaulter s contribution to the default fund CCIL s contribution to mitigate losses on member default is capped at certain percentages of the balance in SRF as stated under: o Securities Segment: 10% of the balance in the SRF at the time of default o Forex Segment:15% of the balance in the SRF at the time of the default o CBLO Segment: 5% of the balance in the SRF at the time of the default Default fund contributions from non defaulting members Cash segments are settled on DVP / PVP basis and counter value to be paid to the defaulter is withheld and margins are blocked till completion of default handling. Hence, only under very extreme scenarios will the defaulter s loss exceed withheld counter-value and prefunded resources. Moreover, due to very little time for settlement (after a default event) auction of defaulter s trades/ positions is not envisaged except for term repo and term CBLO trades which are insignificant in number. In Forex segment, CCIL regulations allow CCIL to close out all outstanding trades of the defaulter If the pre funded default fund contributions from non defaulting members is exhausted, CCIL has the right to call for additional contributions from such members to meet the residual loss and for replenishment of the default fund. The same is detailed under provisions of sub-section (J) of Chapter XIV of Regulations for Securities Segment, under provisions of sub-section (J) of Chapter XIV of Regulations for CBLO segment and under provisions of sub section (J) of Chapter VIII of Regulations for Forex settlement segment. 8

9 3.2.7 As per CCIL Regulations for cash segments, viz. Securities, CBLO and Forex segments, non defaulting members who are active in the segment have obligations to meet loss assessment and default fund replenishment together if defaulting member s loss exceeds prefunded resources. Non adherence to such assessment calls by any member will result in such member being declared as a defaulter. 4.0 Summary 4.1 The proposed steps in recovery phase for Derivatives segments are listed below: 1. Auction (first round) with pre funded resources 2. Cash call in proportion to default fund contributions (already present in CCIL s Regulations) 3. Auction (second round) with contributed resources 4. Forced allocation of residual positions of the defaulter to non defaulters 5. Tear up of all trades of members who failed to honor the margin obligations on account of forced allocation 5.0 The feedback may be ed to rmd@ccilindia.co.in for attention of Chief Risk Officer with the subject reading as Recovery tools at the end of the prefunded Default Waterfall on or before 15 th Mar 17. **** 9