Banking StandardsLetter from Andrew Haldane, Executive Director, Bank of England

Thank you for your letter of 19 November about central counterparties (CCPs). You asked for the Bank’s views on the following questions:

1.What conduct and prudential concerns do CCPs present to the financial system?

2.How might the increasing use of CCPs affect innovation, the location of financial activity, and banking standards?

3.What remedies are there for these issues?

In what follows, we have focused chiefly on prudential issues as these will form the core of the Bank’s new responsibilities for the supervision of CCPs next year. This picks up the points raised by Baroness Kramer in questions during my hearing. We also suggest some places in which the Commission support could be important in helping strengthen CCP resilience.

As background, it is already clear that the landscape for CCPs has changed fundamentally and is set to change further in the period ahead. The G20 commitment in 2009 means that, in the near future, all standardised OTC derivatives will be centrally cleared. So too, prospectively, might an increasing range of non-derivative products. That will result in CCPs becoming an ever-more important node in the international financial network.

The key challenge will be to ensure risk management, at the level of individual CCPs and across the system as a whole, adapts itself to this new financial landscape. Otherwise we will have simply created a new, and potentially even more virulent, strain of the “too big to fail” problem. So what is being done to avert this outcome?

Conceptually, it is possible to think of CCP risk management operating along three key dimensions:

risk management ahead of stress;

recovery plans during stress; and

resolution by the authorities if both of the first two prove inadequate.

All three dimensions are captured in the new international Principles for Financial Market Infrastructures (PFMIs), issued by the Basel Committee on Payments and Settlement Systems (CPSS) and the International Organisation of Securities Commissions (IOSCO) earlier this year. These standards are embodied in the European Market Infrastructure Regulation (EMIR) which takes effect at the start of next year. The Bank will apply the PFMIs, acting under EMIR, when it assumes responsibility for supervising CCPs next year.

Risk Management

The first line of defence for a CCP is risk management. At a CCP, unlike a bank, this takes three forms—there is a “waterfall” of protection against potential losses. First in the waterfall are margins payments by clearing members to the CCP against cleared trades, both initial and variation margin. Second, there is a paid-up CCP default fund financed by clearing members. And third, there is the capital of the CCP.

As Baroness Kramer noted, the capital of CCPs is generally small in relation to the volume of transactions that they clear. That is because the prime protection that CCPs maintain against member default are the other elements of the waterfall—the margin and default fund contributions. Generally, these are many times greater than CCP capital.

The new PFMIs strengthen official policy in relation to CCPs’ margin and default fund contributions. At the same time, new regulatory requirements proposed by the European Banking Authority have also increased the amount of capital that EU CCPs will have to hold in future. A number of infrastructure groups have since announced plans to raise more capital.

Taken together, this means that all three elements of the CCP risk management waterfall have been substantially strengthened over the past year. This is recognition of their increased systemic role.

Unlike banks, CCPs do not engage in maturity-transformation—borrowing short and lending long. Instead they run an entirely matched book. So in ordinary circumstances CCPs should not face significant liquidity risk. But if a large clearing member were to default, the CCP’s book becomes unmatched. The liquidity demands on a CCP could then be very large, particularly in physically-settled markets such as repo.

The first line-of-defence here, as with counterparty credit risk, is the resources that CCPs themselves maintain. International standards have been tightened here too, ensuring CCPs resources are held in a sufficiently liquid form. But to backstop these arrangements, a group of major central banks, including the Bank of England, announced earlier this year that they were “working on how they could ensure that there are no technical obstacles impeding them from providing liquidity assistance to a CCP that is fundamentally sound but faces a shortage of liquidity at very short notice”.1

Baroness Kramer observed that a particular challenge arises in the case of CCPs that operate cross-currency. There are good economic reasons for CCPs operating on a cross-currency, cross-border basis, as this delivers netting benefits. Reflecting that, the Financial Stability Board (FSB) earlier this year identified effective international cooperative oversight arrangements, and appropriate liquidity arrangements for CCPs in the currencies in which they clear, among its “four safeguards” for a global framework for central clearing.2

The Bank is working to ensure these four safeguards are in place for UK-operating CCPs. There will be many authorities internationally with a legitimate interest in the UK’s CCPs, including the regulators of the markets they clear, the prudential supervisors of their clearing members and the central banks of the currencies in which they operate. Once the Bank takes on responsibility for the supervision of UK CCPs next year, it will aim to deliver a sea-change in cooperative oversight with these other authorities, to ensure the resilience of globally operating CCPs with a home in the UK.


As Baroness Kramer rightly pointed out, even if risk management standards for margin and default funds are high and rising, it is impossible to rule out tail events which could exhaust these resources. Indeed, it would be imprudent not to plan for dealing with such events, given the importance of ensuring continuity of CCP services.

CCPs are in many respects a set of rules that determine how any loss will be allocated between members in the event of one or more of them defaulting. Except for some products, CCP rules only cover losses up to the point at which the default fund is exhausted. But in principle CCP’s rulebooks could be enhanced to cover a loss from member default of any size, with the gap allocated amongst the surviving members in a way that kept the CCP solvent and able to continue clearing.

For more than a year now, the FSA and the Bank have been pressing UK CCPs to introduce rules that do precisely this. Usefully, the new international PFMIs now require it.3 Domestically, the Bank’s Financial Policy Committee has supported this work.4 These rules are now starting to be introduced, albeit not yet comprehensively, among UK CCPs. Work is also commencing among other major global CCPs. There is more inevitably to do in this area given the recent introduction of the PFMIs.

To reinforce this effort, the government recently announced that it will consult on changes to the rule-making (so-called Recognition Requirements) for UK CCPs. In future, if these changes are passed, having loss-allocation rules will be mandatory for UK CCPs.5 That would be a significant step forward. Having the Commission support such efforts would be powerful and important.


Even with such loss-allocation rules in place, we cannot be certain that they will necessarily always succeed in their objectives—or at least not without consequences that could be undesirable to systemic stability, such as the cancellation of large volumes of transactions or contagion between loss-bearing member firms.

In order to reduce the potential impact of such outcomes, the authorities need backstop powers in respect of CCPs. The FSB’s requirements for resolution regimes apply to CCPs6 and CPSS-IOSCO have also consulted this year on what those requirements mean for CCPs.7 As you may know, legislation to grant those powers is currently proceeding through Parliament. One issue we face there is that EU legislation introduced before resolution regimes were contemplated, notably the Financial Collateral Arrangements Directive (FCAD), would conflict with the ability of a resolution authority to write-down members’ collateralised claims. This prevents the resolution authority from being able to assure continuity of CCPs services in a situation of extreme stress. The support of the Commission in removing this impediment, in circumstances where stability is at stake, would be extremely valuable.

If all of these changes were to be implemented, which will by itself be a major challenge, they would deal with many of the more obvious sources of CCP stress. We would have, in effect, capital, liquidity, recovery and resolution plans for CCPs. But even these rules will then need to be kept under review. As capital markets evolve and adapt to the new centrally-cleared environment, so too will CCP risk management tools.


Questions of conduct are principally for FCA, but some dimensions are common across prudential and conduct authorities. The role of CCPs is not in general to initiate transactions, but rather to concentrate the risk-management of such transactions. That tends to limit the extent to which pure conduct of business issues arise at CCPs. Nonetheless, it is clearly important that CCPs’ rules on membership (“access”) and its fee schedule are clear and reasonable, particularly once central clearing of some products is mandatory. The PFMIs will require that.

Many CCP issues have both a prudential and conduct dimension. Access is one example, since a CCP’s assessment of the creditworthiness of potential clearing members is a critical risk control. Disclosure is another. We believe that CCPs should routinely disclose more information about their risk policies and models so that their participants are better informed about the CCP’s approach. This is especially important if in future those participants will bear the consequences of inadequate CCP risk management.

Another issue spanning conduct and prudential issues is the segregation of client assets. This was a problem in the cases of the failure of Lehman Brothers and MF Global. The FSA are undertaking a review of the UK client assets regime; at international level, they are being reviewed in a regulatory context by IOSCO and by FSB in a resolution context. It will be important to ensure that it is perceived as being at least as robust as client asset regmes in other international financial centres if business is not to migrate abroad. Currently, that is not always the perception.

Mandatory central clearing will require more market participants to use CCPs, many of them end-users such as funds which are unlikely to join as direct members. For indirect participants, two important benefits of central clearing are the potential for transferring (“porting”) positions to another clearing member if their own should default and for protecting the collateral supporting the client’s positions. EMIR requires that CCPs offer individual clients segregation arrangements.

Innovation, Location of Financial Activity and Banking Standards

As we saw during the financial crisis, OTC derivatives can become a source of systemic risk. It was for that reason the G20 mandated clearing of “standardised” OTC derivatives. This ought to strengthen efforts to standardise financial products in ways which support financial innovation while curbing bad outcomes—for example, the creation of non-standardised, overly complex, structured products, which proliferated ahead of the crisis.

Central clearing does not of course prevent non-standardised products emerging. But those non-standard transactions will in future attract higher capital charges and will be subject to collateral requirements. While international work in BCBS/IOSCO is continuing, this work programme is likely to create stronger incentives for central clearing, and hence for standardisation, of financial instruments.

All of these efforts rather put the onus on regulators to ensure that regulatory requirements of CCPs are calibrated broadly correctly and are directed at those institutions and instruments which bring the greatest systemic risk. That work is underway, with exemptions for institutions and instruments deemed not to generate systemic risk—for example, some non-financial companies and pension funds.

Even once complete reform is complete, it will be important to review the impact of these regulatory measures as they take effect. Inevitably given such comprehensive reform, there will be some unintended consequences and places where regulation may have under or overshot. For what it is worth, so far there is little evidence that the derivatives market is being stifled by these efforts, with outstanding notional volumes of interest rate swaps and FX derivatives, the two largest categories, larger now than at end-2007.8 But it is early to judge.

Regarding the location of financial activity, there will be countervailing forces at work. Much of the risk benefit of central clearing is achieved through the process of multilateral netting. These benefits are greater the more of a market is cleared through a given CCP. So the economics of central clearing will tend towards a concentration of activity in a small number of CCPs. Currently, CCPs operating cross-border on a large scale tend to be based in the major international financial centres, including London.

Working against this is the preference of some market participants to transact through a locally-based CCP. This may reflect factors such as a desire to operate under the local legal framework, notably local bankruptcy and client asset protection arrangements, or simply familiarity and operational convenience. In a few jurisdictions, regulators have established “location requirements” in respect of clearing.9

The intention of the PFMIs, and the FSB’s “four safeguards”, are to provide as far as possible a level international playing field. It would be tremendously dangerous if CCPs were to begin competing for international business by trimming on their risk management requirements. This was the fatal path banking followed and we all know how that ended. That makes implementation of the PFMIs, alongside arms-length reviews of countries’ compliance with these standards, crucial in avoiding a race to the bottom. It is too early to say how fast this race will be run, but early signs are not uniformly encouraging.

Finally, you asked about the impact of the increasing use of CCPs on banking standards. One intention of the reforms to central clearing are to improve transparency and standardisation in cleared markets. If successful, that would tend to reduce a little the scope for mis-selling, rent-seeking and other inappropriate forms of banking behaviour.

There is a massive agenda of work, internationally and domestically, not all of which I have done justice to here. We are very aware that the systemic stakes are high. Over the course of the next few years, we will be trying to prevent this becoming the most likely source of the next systemic crisis.

28 November 2012

1 Financial Stability Board, OTC derivatives market reforms: third progress report on implementation, June 2012, Statement of the BIS Economic Consultative Committee page 48:

2 Financial Stability Board, OTC derivatives market reforms: third progress report on implementation, June 2012, page 3.

3 CPSS-IOSCO, Principles for financial market infrastructures April 2012, page 37:

4 Financial Stability Report, December 2011, pp20–21 and 52-53:

5 Financial sector resolution: summary of responses, October 2012, paragraphs 1.7 and 2.25:

6 FSB Key Attributes of Effective Resolution Regimes for Financial Institutions, November 2011

7 CPSS-IOSCO Consultative Paper on Recovery and Resolution of Financial Market Infrastructure, July 2012

8 BIS, OTC derivatives statistics at end-June 2012:

9 Financial Stability Board, OTC derivatives market reforms: fourth progress report on implementation, October 2012, table 7, page 92:

Prepared 19th June 2013