COLUMN – RANDY PRIEM | The “second skin in the game” – a buffer of money staked by the clearinghouse which was introduced by the EU CCP Recovery and Resolution Regulation – was supposed to be an additional capital buffer and see the CCPs take more responsibility. Reflecting on the systemic discussions at the recent PostTrade 360° Nordic conference, our columnist/panellist Randy Priem was informed by some clearing members that they could now instead be worse off than before.
With over 70 parallel sessions, more than 180 speakers, and upwards of 1,200 participants, it is nearly impossible to summarize all the key insights from the recent PostTrade 360° event in Stockholm. Key topics, such as the transition to T+1, the application of distributed ledger technology, and the Capital Markets Union, were intensely discussed and debated. Consequently, this column focuses on a matter briefly raised during the panel on CCP recovery and resolution, in which I participated, that also merits significant attention. Specifically, it addresses whether the introduction of a second skin-in-the-game requirement has led to an enlargement of the default fund – ceteris paribus all other layers – or simply represents a reallocation of excess capital from the first skin-in-the-game layer downwards in the default waterfall to the second skin-in-the-game level.
Article 9(14) of Regulation (EU) 2021/23 of the European Parliament and of the Council on a framework for the recovery and resolution of central counterparties (“CCP Recovery and Resolution Regulation”) introduced the so-called second skin-in-the-game requirement. That is, this article stresses that following a default or a non-default event, a CCP has to use an additional amount of its pre-funded dedicated own resources, the so-called “second skin-in-the-game”, before the use of the arrangements and the measures referred to in point 15 of Section A of the Annex to that regulation (i.e. arrangements and measures to reduce risk, restructure contracts, restructure business lines, partially or fully terminate contracts, etc.). That amount cannot be lower than 10% nor higher than 25% of the risk-based capital requirements calculated in accordance with Article 16(2) of Regulation (EU) No 648/212 (“EMIR”) stating that a CCP’s capital, including retained earnings and reserves, has to be proportionate to the risk stemming from the activities of the CCP and is sufficient to ensure an orderly window-down or restructuring of the activities over an appropriate time span and an adequate protection of the CCP against credit, counterparty, market, operational, legal, and business risk not already covered by specific financial resources referred to in Articles 41 to 44 (i.e. margins, default funds, first skin in the game). This article was added with Commission Delegated Regulation (EU) 2023/840 which specifies the methodology for the calculation and maintenance of the additional amount of pre-funded dedicated own resources.
Focusing on the structure of a default waterfall, as outlined below, EMIR mandates that the initial resources to be utilized are the margins and default fund contributions of the defaulting clearing member. Should these funds prove insufficient, the CCP’s skin-in-the-game—representing the CCP’s own capital—is then employed. In the event that additional resources are required, the default fund contributions of non-defaulting members are drawn upon, with cash calls to non-defaulting members serving as the final recourse. As highlighted by Duffie (2015) and Cont (2015), skin-in-the-game typically provides CCPs incentives to impose sufficient initial margin requirements on its clearing members and to monitor their creditworthiness. Indeed, if this equity of the CCP has to be used, the initial liquidity risk resulting from default losses transforms into an insolvency risk for the CCP. This will affect the CCP’s shareholders and thus tackle the possible misalignment of incentives between the CCP’s shareholders, its creditors and clearing members, and its management.
The CCP Recovery and Resolution Regulation thus introduced a second skin-in-the-game capital requirement. This capital is typically employed after all default fund contributions have been exhausted, but before additional contributions from clearing members are solicited. The purpose of this second skin-in-the-game is to provide an additional capital buffer, mitigating the risk of allocating losses to clearing members, which could potentially cause a spillover of financial risk throughout the industry and exacerbate procyclical effects. The introduction of a second skin-in-the-game aims to ensure that CCPs bear an even greater financial responsibility in the event of default. By doing so, it incentivizes effective risk management and encourages the prevention of default scenarios. Moreover, it better aligns the interests of the CCP with those of the clearing members and the broader financial system.
At the PostTrade 360° event in Stockholm, it was highlighted that many CCPs historically held more skin-in-the-game capital than the minimum required by EMIR. As a result, the likelihood of needing to draw upon default fund contributions from non-defaulting clearing members in the event of a clearing member default was relatively low. However, with the introduction of the CCP Recovery and Resolution Regulation, which mandated a second skin-in-the-game requirement, several CCPs may have reduced their first skin-in-the-game to the legal minimum, reallocating this capital to the second skin-in-the-game layer instead of increasing the total amount of capital held. This reallocation has left non-defaulting clearing members in a less favorable position, as the likelihood of their default fund contributions being drawn upon in the event of a clearing member default has increased. Furthermore, simply shifting capital from the first to the second skin-in-the-game does not mitigate the risk of cash calls, thereby failing to reduce the overall financial risk.
The veracity of this claim remains to be empirically validated. Moreover, if certain CCPs have indeed undertaken such actions, it would not, in itself, constitute a violation of European regulations. However, such actions may, at least according to clearing members, not align with the intended spirit of the law and should therefore be subject to closer scrutiny by legislators and regulators. In any case, it represents an on-going debate about ‘when things go wrong, who is going to pay for it’. Yet, transparency appears to be crucial for maintaining market confidence and mitigating concerns raised by certain clearing members.
As a senior official of Belgium’s supervisory market authority and member of CPMI-IOSCO’s steering committee, as well as a scholar, Randy Priem continuously monitors the global financial-stability and investor-protection landscape from the very top of the hill. His PostTrade 360° column lets him share informal observations and reflections underway, on subtopics big or small.
Any views expressed are Randy’s personal, not representing positions of his institutions.
