A new report from the Bank of England says that although the
current legal framework around CCP default management is largely robust, the
“piecemeal” nature of this framework presents challenges.
The new paper, written by Jo Braithwaite from the London
School of Economics and David Murphy from the Bank of England, notes that
systemic risk has been “transformed” since the financial crisis, with CCPs
flourishing in these market conditions.
“At the same time, other forces have also been playing out,
such as the move from bearer to intermediated securities, and the increasing
use of collateralisation. It is not unreasonable to call the totality of these
changes an evolutionary jump in financial markets.
“Large scale change can threaten parts of an ecosystem. In
our context, practices that used to be effective may no longer be so, and new
risks can arise. Legal uncertainty is one example of this,” they state in the
Braithwaite and Murphy argue that the current legal framework
for a CCP default largely provides enough certainty and robustness to prevent a
destabilising legal challenge to a CCP. However, they say that given the scale
of the change in market structure and the complexity of the risk transfer being
attempted, it is inevitable that there are still some legal challenges.
“One arises through the piecemeal nature of the legislative
framework. Another is created by the key role of contractual provisions in
derivatives markets: here robustness depends on getting the drafting right,” they
Braithwaite and Murphy say that effective default management
requires clearing houses and their counterparties to have well-drafted
contracts. Despite this, they lay out a number of contractual pitfalls in
current clearing arrangements and suggest some potential solutions to help
The over-arching theme they point out is that, while there
is relatively little case law directly pertaining to CCPs, there is great value
in drawing upon other lessons available from the financial markets.
In particular, they argue that litigation around calculating
Early Termination Amounts under the 1992 and 2002 ISDA Master Agreements, and
around closeout of various types of financial contracts, can provide valuable
lessons for CCPs about how to draft contracts and act in accordance with them
in order to increase legal certainty.
Overall, the paper says that there is
currently “comprehensive, if not complete” support for CCP default management
processes under the various UK and EU legislation.
“One important question is whether so
many domestic and regional sources of law work together wholly coherently:
there are some areas where the issues here are substantial enough to warrant
consideration of further legislation.
“Clearing houses should be aware that
it is impossible to preclude the possibility of legal challenges to a complex
aspect of a complex industry. It is only by paying close attention to the
underlying legal framework, and by looking beyond the sector in order to learn
from the experiences, shocks and evolutionary leaps in other parts of the
financial markets that CCPs will be in a strong position to manage these risks.
“Notwithstanding all this, the
construction of legally robust default management procedures can be approached
with some optimism by the well-advised. The issues are sometimes delicate, but
the legal framework has proved capable of providing substantial legal certainty
despite the evolutionary jumps that financial markets are prone to display,”
the paper concludes.