10 June 2015

Moscow Exchange has begun to develop a new multi-stage protection and loss compensation framework, to be used in case of extraordinary defaults. The framework is designed to use the central counterparty (CCP) liability limit, enabling NCC Clearing Bank to maintain capital adequacy even under extreme market stress conditions and making it possible for the market participants to ensure continuity of the exchange trading.

Mr. Alexey Khavin, Chairman of the Board of NCC Clearing Bank, in an interview with RIA-Novosti News Agency tells about the advantages of the new losses allocation framework and forthcoming changes.

- Would you, please, explain how the framework for allocation of losses occurred due to a single participant’s default works at present, and what changes are to be introduced?

- Currently, losses from a single participant’s default are covered, primarily,  by   the defaulter’s initial margins posted with the central counterparty in course of market trading, and also by his   guarantee fund contribution. If these resources are not  sufficient, then the NCC Clearing Bank’s dedicated proportion of own capital is used, followed by guarantee funds’ contributions of non-defaulting participants , and after that, if necessary – by all of NCC Clearing Bank’s remaining capital (46.2 bn roubles as of 01 May 2015).

It is worth mentioning  that such protection framework is currently operative in the FX market and securities market. As for the derivatives market, as well as in OTC derivatives segment -  in the most risk-intensive segments of the exchange market – from the initial stage of these markets’ functioning  there has been a liability limit set for a clearing organization (NCC Clearing Bank), whereunder the size of potential losses assumed by the Bank is limited to a certain fixed amount. If all of the abovementioned tools are exhausted, then, to cover the remaining portion of losses, NCC may use the framework for allocation of losses  among non-defaulting clearing participants.

- What changes will follow the new framework introduction?

- The main novation is that there will be the introduction of the central counterparty liability limit in the securities market and FX market: i.e. the Bank will apply   the approach identical to the one that always exists in the derivatives market.   The liability limit will consist of a dedicated proportion of  the CCP’s own capital (which is globally known as “skin in the game”) and additional capital, which is limited due to the need for NCC Clearing Bank to comply with minimum regulatory capital requirement (capital adequacy ratio should not fall below 10%) in order to continue operation as central counterparty and ensure continuity of exchange trading. At that, the same as currently, losses primarily will be covered by the defaulter’s initial margins and by his   guarantee fund contribution. In case of an extremely negative market situation, when all previous elements of the protection framework are exhausted, the Bank may activate the framework for allocation of losses among non-defaulting clearing participants.

- And what is the probability that the framework for allocation of losses among non-defaulting clearing participants  is activated?

- NCC Clearing Bank uses the confidence probability level exceeding  99.9%, thus minimizing the probability of resorting to the said loss allocation framework; therefore, we may rather talk about a hypothetical case of insufficiency of coverage in form of individual and collective contributions of participants and  dedicated capital of NCC Clearing Bank.

- How large will be the dedicated proportion of the NCC’s own capital and the Bank’s additional capital?

- Right now, providing any concrete figures would be premature. Internationally, dedicated capital cannot be lower than 25% of minimum regulatory capital of the central counterparty. I suppose that the Russian regulation will be based on the same approach. Therefore, dedicated capital will be increasing along with growth in business volumes and trading volumes. As for the size of the additional capital, initially, this figure will not be fixed anywhere. I guess that the additional capital issue will be resolved in case of a truly extreme negative market scenario, considering many factors, including the specifics of the market where the default has occurred, the current need of NCC Clearing Bank for regulatory capital at the moment of the default, and other factors.

- Do you have any statistics on the loss compensation arrangements previously used in case of market participants’ default?

- Previously, in case of defaults in the Russian market, the participants’ losses were settled only through the use of initial margin posted by the defaulting participant, without resorting to guarantee funds or capital of NCC Clearing Bank. As for the international practice, even in the case of the massive bankruptcy of the investment bank Lehman Brothers, central counterparties of several countries used only the first two protection elements: the defaulter’s initial margin and his collective fund contribution. Therefore, the risk management framework currently used by NCC Clearing Bank, together with the forthcoming unified protection framework, will operate to minimize the probability that the framework for allocation of losses among non-defaulting clearing participants is activated.

- What are the benefits of the new loss allocation framework?

- By introducing the central counterparty liability limit and the single CCP protection structure across all segments of the exchange trading, NCC Clearing Bank will be able to maintain minimum capital adequacy for central counterparty operation even in extreme market stress conditions, and to assure market participants of exchange trading continuity. The proposed changes are aimed at l strengthening overall stability and reliability of the Russian financial system and protect market participants from systemic risk.

- Why is it now that there is a need to change the existing loss allocation framework?

- The development of this new central counterparty risk protection framework has been initiated by the Bank of Russia; this framework conforms to the requirements of the international regulator CPMI-IOSCO (Committee on Payment and Market Infrastructures - The International Organization of Securities Commissions) and the European EMIR (European Market Infrastructure Regulation). The major international central counterparties have already brought their activities in this field in compliance with the requirements of international and national regulators. Since NCC Clearing Bank intends to comply with the requirements of the European market regulator ESMA (European Securities and Markets Authority) and plans to obtain from the latter a qualification status in the foreseeable future, the introduction of the discussed protection framework is one of the most important preconditions for achievement of the Bank's objectives.

- What reaction do you expect from market participants  on your novations?

- The new multi-stage protection framework with CCP’s liability limit is more familiar to foreign market participants, since it conforms to international standards. All market participants value transparency of the central counterparty’s actions and its capability of providing services in situations, including the ones where conditions are extreme. Once the new multi-stage protection framework is implemented, NCC Clearing Bank’s predictability and transparency will undoubtedly increase.

And, indeed, everybody is interested in further development of the Russian financial market and growth of its liquidity, including the same through increase in non-resident transaction volume, which may become possible if NCC Clearing Bank obtains the abovementioned qualification from ESMA.

- When do you expect to introduce the new framework? Will you discuss it with market participants?

- The introduction of the new multi-stage protection framework is scheduled for the running year. We have already started discussing this new loss allocation framework with market participants; in particular, in May, it was presented at the meeting of the Securities Market Committee of Moscow Exchange.