Resolution of Central Counterparties (CCP)
On 31 May 2022, the Swedish Parliament decided that the National Debt Office will be the resolution and support authority for central counterparties. In Sweden, there is one central counterparty, Nasdaq Clearing AB. Central counterparties have become increasingly important players in financial systems and play an important role for financial stability.
As of 12 August 2022, National Debt Office resolution tasks will be extended to include central counterparties. These companies act as intermediaries between buyers and sellers in financial transactions and thus take over the obligations that the seller of a financial contract has towards the buyer of the contract and the rights that the buyer has towards the seller. The central counterparty thus becomes both buyer and seller in the deal and takes over the counterparty risk that arises between two actors from the point in time they enter into a financial contract until the time their business is concluded (see the fact box below).
The resolution regulations for central counterparties differ in some respects from those that apply to banks. However, the purpose is the same, i.e., to ensure orderly crisis management and thereby maintain financial stability.
Resolution becomes relevant if a central counterparty suffers serious problems that cannot be managed through the financial buffers and other protection mechanisms that the counterparty itself has built up. Through resolution, the National Debt Office takes control of the central counterparty and takes measures necessary to maintain its critical functions. The National Debt Office has a number of different tools at its disposal:
a) Tools for covering losses and closing positions.
b) Impairment and conversion of ownership instruments, debt instruments, or other unsecured obligations.
c) Sale of operations.
d) Transfer of operations to a bridge institute, after which they can be wound down or restructured in an orderly manner
Ultimately, there is also an opportunity for the state to take over the ownership of the counterparty and contribute new capital - the state stabilisation tool.
To carry out resolution in the best possible manner, when it becomes necessary, the National Debt Office must plan and maintain preparedness. This is primarily achieved through a Resolution Plan, which must be drawn up and updated annually. The Resolution Plan describes the tools and powers the National Debt Office plans to apply if the counterparty defaults, how the counterparty’s critical functions will be maintained, and how the central counterparty may be reconstructed. If the National Debt Office planning identifies obstacles to implementing resolution, requirements may be imposed on the counterparty to remove these obstacles.
Measures aimed at avoiding resolution
Although resolution provides the preconditions to deal with failing counterparties efficiently, it is a last-resort option that should be avoided to the greatest extent possible. Consequently, the resolution framework also contains rules aimed at protecting central counterparties from problems so serious that they must be put into resolution.
The central counterparty must establish a Recovery Plan, which must state the measures the counterparty itself can take in the event of a significantly-deteriorated financial position or when there is a risk that it may violate the requirements of the regulatory framework. The Recovery Plan will be reviewed by the Financial Supervisory Authority and the National Debt Office.
If a central counterparty is at risk of suffering major financial losses or if its actions may be harmful to financial stability, the Financial Supervisory Authority can step into the counterparty operations before the situation has reached such a point that resolution is the only way out. These early interventions include, among other things, the Financial Supervisory Authority enforcing measures from the Recovery Plan.
Preventive state support
If necessary to counteract serious disturbances in the financial system in Sweden, the National Debt Office can provide preventive government support for the central counterparty through guarantees. Preventive government support can also be provided through guarantees to the Swedish Central Bank for repayment of liquidity support that the bank has provided to a central counterparty. Preventive state support may be provided for continued operations in a central counterparty that is viable. This support must be temporary and proportionate to the seriousness of the disturbance.
The importance of central counterparties in managing financial risks
A central counterparty (often abbreviated as CCP) is a company that is tasked to take over the counterparty risk that trading in, above all, derivatives entails. A derivative is a financial instrument whose value is based on one or more underlying assets.
A central counterparty contributes to more secure trading by acting as buyer to all sellers and seller to all buyers in transactions involving financial contracts. The central counterparty thus becomes a counterparty to both the buying and the selling parties. Bilateral counterparty risk is thus replaced with counterparty risk to one actor - the central counterparty.
Before the 2008 financial crisis, the majority of trading in derivatives took place directly between the parties who wanted to buy or sell a particular derivative contract. The trade took place outside regulated markets and was cleared by the parties themselves. The lack of regulation led to major risk levels in the financial system. In combination with a lack of transparency in the bilateral trade in derivatives, substantial spillover effects were generated during the financial crisis. In the years that followed the financial crisis, new regulations were therefore put in place to bring about the increased use of central counterparties:
- In 2009, the G20 countries agreed that all standardised derivatives traded outside regulated trading venues, i.e., OTC derivatives, should be cleared via central counterparties by 2012 at the latest.
- In 2012, EU Regulation No. 648/2012 on OTC derivatives, central counterparties, and transaction registers entered into force. This regulation is called EMIR (European Market Infrastructure Regulation) and aims at increasing transparency and reducing risk in the derivatives market. EMIR contains, among other things, requirements for reporting all derivative contracts to transaction reporting, mandatory clearing of standardised OTC derivatives via central counterparties, and techniques for managing risk.
- In 2022, EU Regulation No. 2021/23 on the recovery and resolution of central counterparties (commonly abbreviated CCP RRR) was adopted, which, together with Swedish legislation that provides supplementary regulations, appoints the National Debt Office as the resolution authority for central counterparties. The regulation and the supplementary legislation apply from 12 August 2022 with certain exceptions.
The CCP safety net
While a central counterparty contributes to more secure trading, it does expose itself when it takes over counterparty risks from other actors. Consequently, in the regulations that were added after the crisis (see above), there are several levels of safety net for possible losses that may arise in the operations of a central counterparty, above all if one of the actors involved should fail. The central counterparty must, among other things, hold a certain amount of pre-funded resources. These consist primarily of financial collateral that the members of the central counterparty require to cover any future exposure to the member who provided the collateral and also of funds that all members have paid into an insolvency fund. As a third measure, the central counterparty must ensure that the organisation itself has sufficient financial resources, which, together with the default fund, ensure that the institution can withstand the failure of the two largest clearing members at the same time in extreme but conceivable circumstances.