The central clearing of OTC derivatives is a key element of the post-crisis financial markets reforms. It offers numerous benefits for financial stability including the multilateral netting of cleared exposures and the centralisation of default management. However, given the pivotal role of central counterparties (CCPs) in the new financial system, the question naturally arises whether CCPs will be able to manage a large member default effectively.
There are various aspects to this question, and in a recent paper my co-author and I concentrate on one of the least studied: the legal certainty of CCP default management processes. This aspect is important because the prospect of a legal challenge to a CCP could be destabilising, and the legal framework within which CCPs operate is a complex and, in some areas, newly constructed one. Bankruptcy law, the law of collateral, and various special arrangements (such as the financial institution resolution framework and the rules around settlement finality) all apply, often at both national and European levels.
Against this background, we evaluate the diverse legal rules governing CCP default management by investigating the extent to which they provide adequate legal certainty. There are five key areas which we focus upon:
1. The processes of clearing and collateral posting. The paper examines these processes in detail, establishing the nature of the rights which CCPs rely upon when managing defaulting members given how collateral actually moves.
2. The relationship between CCP default management processes and insolvency law. This is important as defaulting members are sometimes (but not always) insolvent.
3. Declaring default. A CCP cannot manage a default that it has not declared. We discuss the issues around this declaration, and the duties owned by the CCP to the defaulter.
4. Returning to a matched book. This is the process by which the CCP auctions or otherwise risk manages the defaulter’s portfolio. We discuss the insights into this process which are available from bilateral OTC derivatives case law.
5. The use of collateral. Once a CCP has closed the defaulter’s position, collateral is potentially available to mitigate any loss. However, as in many situations involving financial collateral, care is needed to ensure that the collateral the CCP thinks is available really can be used as it intends.
Our overall findings are that English and EU law provide legal certainty for many aspects of CCPs’ default management processes, but some challenges remain. One set of challenges arises through the piecemeal nature of the legislative framework. For example, we highlight the inconsistencies between different legislative definitions of default management rules, and shortcomings in the legislative protections afforded to floating charges over financial collateral. Other challenges which we identify relate to CCPs’ contractual drafting. We outline, for example, the pitfalls around grace and notice period drafting in Events of Default clauses, and the potentially significant implications of a CCP having discretion over the conduct of particular phases of the close out process. The paper concludes with detailed recommendations with respect to both legislative and drafting issues.
Jo Braithwaite is an Associate Professor in the Department of Law at the London School of Economics and a Research Associate of the LSE Systemic Risk Centre.
This post is based on: J. Braithwaite and D. Murphy ‘Got to be certain: The legal framework for CCP default management processes’ (2016) Bank of England Financial Stability Paper 37, available here.