A Perspective from Market Makers
Optiver, as one of the largest market making firms in the world, supports legislation that gives regulators and CCPs effective tools to ensure CCPs’ functions are preserved in times of crisis
Recovery and resolution of an ailing CCP should be viewed as a public utility function, requiring ex-ante guidelines and principles for the use of all tools with a focus on balancing the interests of all involved stakeholders and avoid cost to taxpayers
Participants need transparency over the criteria for use of specific recovery tools and the scope of their application
VMGH and partial tear-ups could disproportionately affect market makers which have hedged positions. They introduce contagion effects with systemic implications that could lead to new defaults of investment firms and clearing members that are connected to other CCPs
Tear-ups (full and partial) and VMGH are actually so impactful that we believe they should only be used in resolution situations. Also tear-ups could potentially ‘jump’ the waterfall. We feel therefore that cash calls are the preferred tool for recovery.
To reduce systemic risk, an exemption from applying VMGH and tear-ups for any trade done under a MiFID II regulated market making agreement should be considered.
CCPs perform a critical role in financial markets. We welcome the legislative proposal by the European Commission to ensure that CCPs and national authorities have the means to act decisively when a CCP falls into a crisis scenario. The proposed rules will contribute to the aim of ensuring that CCPs’ critical functions are preserved while maintaining financial stability. They will also help to avoid the costs associated with the restructuring and the resolution of failing CCPs being transmitted to taxpayers.
When developing an effective recovery and resolution framework for CCPs, colegislators should ensure that the use of recovery and resolution tools included in the CCP R&R toolkit factors in an appropriate balance of the interests of the CCP, the clearing members, and the participants. This in turn also means that lossallocation in recovery should be proportionate to the risks posed by participants to the CCP and that loss allocation should be capped, with the ultimate objective of limiting contagion and systemic risk.
If a CCP runs into trouble it will be in a period of serious market stress. During such periods of market turbulence, it is critical that market makers can remain in the market to provide liquidity to prevent markets to come to a complete standstill. When designing the toolkit for recovery and resolution of CCPs it is therefore fundamental to ensure that those tools do not force markets makers to stop providing the necessary liquidity
2. Aligning incentives
To align incentives of the CCP with other market participants, one of the tools that could be used is “Skin-in-the-game (SITG)”. SITG mandates CCPs to use a dedicated amount of own resources that is equivalent to its minimum capital requirement prior to applying position and loss allocation tools for default losses. As stipulated by EMIR this SITG is set at 25% of the CCP equity, which creates incentives for CCPs shareholders to keep equity low. Allowing for further own resources of the CCP to be used in recovery and resolution (before exhausting the default waterfall and utilising position and loss allocation tools) would signal to participants that the CCP has strong confidence in its risk management processes. It would better align the incentives of the CCP with those of its participants. The amount of SITG should not be related to equity, but be based on a standard valuation model, taking into account the peak risk position within the CCP over a specified lookback period.
Equally, to contribute to an alignment of incentives amongst market participants the allocation of losses should be proportionate to the risks posed by the participant to the CCP.
3. Guiding principles for use of toolbox
In order to minimise market instability in the event of a recovery and resolution scenario, market participants (and clearing members) need to to have ex-ante clarity over what tool box is applicable at a CCP and what the procedures and criteria are for deploying individual measures in the toolkit. A CCP’s rulebook should provide clarity to participants over what triggers the use and scope of individual recovery tools and what pricing references will be used in loss-allocation. Overall, as part of creating recovery and resolution frameworks for CCPs, clearing participants need to have more clarity over the timing of entry into resolution – e.g. move from recovery phase and attempting to restore the CCP to a matched book to resolution.
To provide participants with more certainty, any use of recovery tools should ensure a balancing of the interests of all stakeholders, allocate losses in a proportionate manner to the risks being brought to the CCP by each participant, and cap the overall amount of losses that can be allocated with the ultimate objective of reducing systemic risk.
In the Annex to this paper we have assessed the different recovery and resolution tools based on these principles. In the rest of this paper we would like to share our concerns on two specific tools, which – if not applied with the necessary caution – could actually introduce more systemic risk in the financial system.
4. Tools that may increase systemic risk
Use of Variation Margin Gains Haircutting (VMGH) or partial tear-up of contracts as recovery and resolution tool could have destabilising effects on the wider financial ecosystem and – in the case of VMGH – undermine the No-Creditor-Worse off (NCWO) principle. Application of both tools could also disproportionately affect market makers and undermine their ability to provide crucial liquidity in stressed market conditions.
4.1 use of vmgh
CCPs settle the gains and losses of members’ futures positions on a daily basis, with either the buyer or the seller of a futures product receiving variation margin depending on whether the price of the future has gone up or down.
Market Making firms typically have fully hedged positions, meaning that the futures position in one CCP will be hedged with an offsetting position in a different but related product (potentially with a different CCP). So the variation margin ‘gains’ of a market maker is never a profit, but a hedge for a loss making position. This is important to take into account at it has important implications for the potential systemic impact of applying VMGH:
For market making firms (and other institutions that have hedged positions) the
impact of VMGH is completely dependent on (1) which products they have traded
(e.g. options or futures) and (2) which side of the trade they are on (buyer or seller).
Some market makers will be completely unaffected by VMGH, while others will be
potentially put out of business, creating an element of randomness in the impact of
the tool. For that last group winding down the CCP under normal bankruptcy rules
would have been more attractive, as it would have allocated losses more evenly
amongst market participants. VMGH in this sense also undermines the NCWO
Also, and from a more practical point of view, as VMGH only applies to “gains” on only futures products, the base for recouping funds for the CCP is much smaller than in the case of other recovery and resolution tools.
If a CCP is in financial trouble, it will most likely be in a period of financial stress, potentially with multiple clearing members defaulting more or less simultaneously on their financial obligations. In those circumstances market volatility and volumes are likely to be very high, with extremely large variation margin ‘profits’ and ‘losses’ on futures positions. Applying VMGH on the positions of market makers in such a situation risks that these market makers will default on their obligations arising from the loss-making counter (hedge) position. This could subsequently bring down clearing banks who have guaranteed these market makers’ positions and introduce contagion risk towards other CCPs.
4.2 use of partial tear-ups
Equally, whilst using tear-ups – e.g. tear-ups of the contracts of the defaulting clearing member within a product group (i.e. partial tear-up) – as a position allocation tool that only targets the non-auctioned positions could enable the CCP to continue clearing a product group, it could also create unforeseen market risks, particularly in the case of partial tear-ups. Like VMGH, partial tear-ups could unbalance the portfolios of clearing participants (including market makers operating with a fully hedged portfolio). Such partial tear-ups could lead to fully hedged positions of market makers becoming unhedged because one of the legs of a hedging pair or multiple legs of a hedging strategy are torn up. Just like the application of VMGH, PTU risks the default of market participants with potential systemic contagion effects that could jeopardise clearing members and other CCPs. Therefore, a situation where the where the resolution authority cancels all contracts in a certain product segment (i.e. full tear-up), are preferable over partial tear-ups.
Partial tear-ups also risk disproportionately affecting participants over clearing members as clearing members do not hold positions with the CCP (so they will always prefer tear-ups). It also risks undermining the auction process because there would be limited incentives for clearing members to bid in the auction process when the CCP is liquidating the positions of the defaulting clearing member(s).
4. Proposed way forward
As we have explained above, tear-up of contracts (both full and partial) and VMGH are so impactful that we feel they should not be used in recovery situations. We feel that cash calls are the preferred instruments in recovery scenarios.
Under MiFID II all market makers have an obligation to enter into a market making agreement, and all orders sent to an exchange under that agreement should be flagged as such. Thus it is very easy to identify all transactions that will have an associated hedge position. Excluding from applying VMGH or tear-ups those trades that were done under a regulated MiFID II market making agreement (and flagged as such) will limit the potential contagion risks associated with these tools and ensure that market makers will not be forced to stop fulfilling their essential role as liquidity provider in times of market crisis.