Japan's CCP connundrum Monday, March 14, 2011
Derivatives Week 14th March 2011 edition is reporting that Japan's Regulators are seeking to provide clearing members with limited liability at the same time as preserving the local law which precludes a CCP from going bust.
The reported solution for who should pick up losses in the event of a default exhausting the resources of the CCP, which includes capped contributions of surviving members, is to declear trades back to their original counterparties.
This is an awful solution, widely rejected in almost all major CCPs, for several reasons.
Firstly, it removes certainty from clearing. As a consequence, counterparties will retain a contingent exposure to their original counterparty, with a consequential capital requirement.
Secondly, in most CCPs, trades are offset with each other to create net positions with the CCP. Under this model, one clearly cannot net trades since preserving the identity of the original counterparty is essential if trades are to ever be re-allocated back. As a result, whilst one may have exited a position some months/years ago, a potential exposure remains if those trades are ever unwound by the CCP to revert back to a bilateral exposure. To close such an exposure in the ordinary course of business, one may have to do offsetting trades with the original counterparty, but even that may not suffice depending upon how the CCP determination of unallocated trades works.
Whilst members cannot be exposed to an unlimited liability in order to keep a CCP afloat, and the possibility of a CCP failure sends terror into the heart of regulators, operating contingent clearing simply creates other unpalatable problems.
I sincerely hope that the groups working on this will come up with a more palatable solution, hamstrung as they are by the notion that a CCP may not go bust.