Fitch: Fed's First Prudential Rules for CCPs Will Likely Evolve

The Federal Reserve's final risk standards for central counterparties (CCPs) and other financial market utilities (FMUs), which include minimum equity and liquidity standards, constitute a first step in regulating these entities that will likely evolve, Fitch Ratings says. Counterparty, operational and potential systemic risks are rising at CCPs as mandatory clearing for certain products takes effect and volumes are expected to increase, so the initial prudential standards may need to be enhanced.

The initial requirements appear reasonable, but they are difficult to assess in terms of their sufficiency, especially as risks to these financial infrastructure companies continue to shift.

The standards are designed to ensure that FMUs manage credit risks arising from payment, clearing and settlement processes. For example, a CCP is specifically required to hold additional prefunded financial resources to cover stresses, including the default of the two largest participants, known as a "cover 2" requirement.

Under the liquidity requirement, an FMU will have to hold sufficient unencumbered liquid assets to cover the greater of the cost for the firm to recover or wind-down from general business losses according to its plans, or six months of current operating expenses. Although there are no capital rules as such, common equity has to be at least equal to the amount of unencumbered liquid assets held under the liquidity rule.

The risk management standards should help ensure more robust risk controls and improve CCPs' overall credit profiles, all else being equal. This could offset some of the additional risks arising from higher clearing volumes. But the extent to which these rules would lower the risk for senior bondholders will depend on the effectiveness of recovery plans.

Importantly, recovery and resolution plans are mandated by the regulation. The guidance on recovery planning for financial market infrastructure companies, published on Oct. 15 by the Bank for International Settlements' Committee on Payment and Market Infrastructures (CPMI) and the International Organization for Securities Commissioners (IOSCO) includes specific recovery tools, which should improve the enforceability and effectiveness of the plans. It also envisages that the allocation of losses is set out before the losses are incurred (ex-ante).

Senior creditors are likely to become part of the waterfall, but bail-in is not explicitly set out in the regulation. Senior bondholders may absorb losses at an earlier stage of the recovery process, potentially through voluntary debt restructuring or if ex-ante arrangements regarding bail-in are made. But this is unclear at this early stage of regulation for financial market infrastructure companies.

The US is the first country to adopt the principles for financial market infrastructure companies developed by the CPMI and IOSCO. The Fed published its final rules for financial market utilities on Oct. 28. The Fed has requested that compliant recovery and orderly wind down plans be put in place as soon as possible, but no later than Dec. 31, 2015.

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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