Thin-skinned: are CCPs skimping on capital cover?

Clearing member contributions to the default funds of major central counterparties have ballooned in recent years. Yet the amount of capital clearing houses are stumping up in reserve cash – their so-called skin in the game – has failed to keep pace.

It’s a development that highlights the lack of an agreed global standard on a minimum level for CCP cash reserves, how such a minimum would be calculated – or whether it should be calculated at all.

Skin in the game, or SITG, isn’t intended to be a means of loss-absorption for most CCPs – it’s far too small for that. LCH’s Paris-based CDSClear, for example, had €20 million ($21.4 million) of first-tranche SITG and €11.3 million of additional reserves, known as second skin in the game, in the second quarter.

These reserves are a drop in the ocean compared with the division’s initial margin of €9 billion and clearing member contributions to the default fund of €3.7 billion.

Some commentators even go so far as to say any amount of SITG is too much

Nonetheless, the main role of skin in the game is to incentivise CCPs to effectively manage risk. It serves this purpose better than the contributions of non-defaulting clearing members, which have no way of influencing the risk their peers are taking – unlike the CCP.

The question of where SITG should be set is therefore one of how powerful incentives need to be, when set against trade-offs such as higher clearing costs for members. The ideal proportion of the default fund sourced from CCP capital varies depending on who you ask – suggestions range from 8–10% to 15–20%, and 20% flat.

But CCPs argue that incentives are strong enough as they are – that if SITG were to be standardised, it should be in relation to a CCP’s own resources, not a measure of the risk it is managing. They point out that SITG is often high relative to CCPs’ profits, suggesting this is enough to incentivise sound risk management.

Some commentators even go so far as to say any amount of SITG is too much – that the impact of a default on a CCP’s share price and, by extension, on the pay and portfolios of its executives, is enough to incentivise sound risk management.

A look at how quickly share prices rebound after defaults, however – for instance in the case of Nasdaq following the Einar Aas default in 2018 – calls this into question.

Nor do these arguments address the idea that as a risk management incentive, SITG should scale with the amount of risk being managed, as the European Systemic Risk Board suggested back in 2015. Applying this perspective invites increasingly unflattering comparisons with the level of default funds.

Even the argument that a CCP’s contribution should be compared with that of an average member, rather than the aggregated amount of the default fund seems a little thin. In 2020, when a spokesperson for CME made this point to Risk.net, the CCP’s futures and options unit had an average member contribution of $87.1 million and a SITG of $100 million. Since then, the average member’s input has risen to $131.5 million – but its SITG remains unchanged.

Avoiding regulatory arbitrage

Yet the biggest problem concerning the measure is the lack of standardisation across jurisdictions. Whereas Singapore and the European Union have requirements stipulating minimum levels of SITG, they are in relation to different benchmarks – 25% of the default fund in Singapore and 35–50% of regulatory capital requirements in the EU. No other jurisdictions set minimums.

This allows for outliers, such as the Canadian Derivatives Clearing Corporation, where the C$5 million of own capital is dwarfed by its default fund of C$3.4 billion.

The CDCC’s President, George Kormas, says that a regulatory minimum could distort more than it helps: when setting the level of SITG a CCP’s size, the structure of the market and the nature of the risks being taken all need to be taken into account.

Whatever the appropriate minimum, some degree of standardisation is vital to prevent CCPs in more lax jurisdictions from developing a competitive advantage over those subject to stricter regulation.

Whether such a standard will ever come to pass is another question. For now, the capital many CCPs use to incentivise good risk management is remarkably thin – and not directly correlated to the level of risk in the system.

Given the systemic nature of CCPs, it seems many of them are too thin-skinned.

Editing by Louise Marshall