Till def(ault) do us part: reassessing counterparty risk between global systemically important banks and central counterparties

Christopher Cononico, Ben Kastner and John Williams

Journal of Financial Market Infrastructures

Abstract: Legal changes to strengthen the risk profiles of global systemically important banks (G-SIBs), such as the “orderly unwind†regulatory mandates, have also bolstered the risk profiles of central counterparties (CCPs) and their ability to provide payment, clearing and settlement services in catastrophic scenarios, such as the bankruptcy and resolution of a G-SIB. We examine the extent to which prepositioned liquidity at GSIBs may now be readily available to CCPs after a G-SIB resolution has commenced and before a forced closeout is necessary, allowing the G-SIB to continue trading with CCPs unless and until this liquidity runs dry and a payment default occurs. This approach differs significantly from traditional insolvency analysis, whereby the debtor’s on-balance-sheet resources are unavailable until distributed by the court, an approach of little help to CCPs, which generally rely on daily margin posting. We explore the regulatory framework that bestows preferred-creditor status on CCPs and use a commonsense catastrophe scenario to highlight that prepositioned liquidity at G-SIBs (as required by resolution plans, Basel III’s liquidity coverage ratio and other regulatory mandates) may be sufficient to meet even catastrophic loss scenarios (which could materially impact surveillance, counterparty risk assessment, bank funding plans and certain rating agency outcomes) without CCPs needing to rely on their default resources.

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