Financial market infrastructures (FMIs) are the backbone of the financial system. They enable market participants to transact with one another in an efficient manner. FMIs are inherently systemic, as their very names imply – payments systems, securities settlement systems (SSSs), and central counterparties (CCPs). If an FMI were to cease operations, it could put a stop to payments and/or securities and derivatives transactions. That in turn could destabilise financial markets and possibly the economy at large.
In effect, FMIs are ‘single points of failure’. They reduce risk as long as they remain robust, but they concentrate risk, and serve as a conduit for contagion if they do fail. Moreover, the risks posed by FMIs are highly correlated. Each global systemically important bank (G-SIB) is generally a member of several FMIs, so that if a G-SIB enters resolution, many or all FMIs may come under pressure at the same time.
Two responses are in order: the first is to make FMIs less likely to require resolution; the second is to improve the resolution regime applicable to FMIs. Considerable progress has been made with respect to the first item. As a result of post-crisis reforms to regulation and supervision, the G-SIBs that are the most significant FMI participants are much less likely to fail. And thanks to resolution reform, if such a G-SIB participant were to fail, there is a much greater likelihood that the bank could be stabilised and restructured without taxpayer support. Even if a participant does default on its obligations to an FMI, this does not imply that the FMI itself will enter resolution. For example, under European Market Infrastructure Regulation, CCPs are required to be able to withstand the simultaneous default of their two largest counterparties (‘Cover 2’). So the failure of a FMI should be an extremely remote event – a ‘tail of the tail’ risk.
But it is still an event that could conceivably occur, and if it did occur it could have catastrophic consequences. Therefore, it is of the utmost importance to ensure that FMIs are resolvable, i.e. that each FMI can fail, be restructured and resume operations, all without receiving taxpayer support.1 To this end, the Financial Stability Board has developed key attributes for an effective resolution regime for FMIs (FSB 2014), and the European Commission is now considering legislation that would implement such attributes for FMIs in the EU.
The CEPS Resolution Task Force welcomes such legislation and offers policymakers the following four recommendations.
- Coordinate, coordinate, coordinate
By definition and design, FMIs impact the entire market as well as each of their participants and users. In particular, FMIs are closely interconnected with G-SIBs, who are their principal members. FMIs are also interconnected with one another. Resolution at one FMI could therefore impact all G-SIBs, other FMIs, and the markets at large. Consequently, coordination is critical not only within the EU but also between the EU and third countries, especially the US. This should start with resolution plans and continue during recovery/runway into the actual resolution, including both the stabilisation and restructuring phases for G-SIBs headquartered or active in the EU, as well as for the FMIs inside and outside the EU in which such G-SIBs participate.
Figure 1 Coordination can contribute to continuity
FMI should allow resolution authority time to stabilise failed G-SIB
In particular, the FMI’s supervisor and resolution authority should coordinate closely with the resolution authorities for a failed G-SIB member. The FMI should give the G-SIB’s resolution authority an appropriate amount of time to attempt to stabilise the bank in resolution. This would allow the bank to continue to meet its obligations to the FMI, so that the FMI need not even initiate its recovery procedures. If necessary, the FMI supervisor should make use of its early intervention powers to achieve this outcome.
However, there is a limit to the amount of time that the FMI can give to the resolution authority of the failed G-SIB, because the FMI (as well as the supervisory and resolution authorities responsible for it) will need sufficient time to put in place the recovery and, if necessary, the resolution measures needed to ensure the continuity of the FMI’s critical economic functions.
- Identify and remedy impediments to FMI resolvability
Removing impediments to FMI resolvability can accelerate the resolution of the FMI (and therefore allow more time for the resolution authority of the failed G-SIB member to stabilise the G-SIB). In particular, CCPs (especially those without readily available alternatives) should take steps to ensure that the loss allocation (‘waterfall’) process can be completed, if necessary, over a ‘resolution weekend’. This includes steps to accelerate the auction of the failed member’s positions as well as provisions to replenish the default fund immediately, if it becomes exhausted.
Taken together, these recommendations would go a very long way towards ensuring that FMIs could continue to operate even under extremely adverse circumstances. That in turn would make a significant contribution towards financial stability.
Author's note: The author is a partner in EY’s Financial Services Risk practice and chairs EY’s Global Regulatory Network as well as the CEPS Resolution Task Force. The opinions expressed here are personal.
Committee on Payment and Market Infrastructures and Board of the International Organisation of Securities Commissions (2014), Recovery of financial market infrastructures
Duffie, D (2015), "Resolution of Failing Central Counterparties", in K E Scott, T H Jackong, and J B Taylor (eds.), Making Failure Feasible: How Bankruptcy Reform Can End "Too Big to Fail", Hoover Institution Press, 87-109
European Commission Directorate-General for Financial Stability, Financial Services and Capital Markets Union (2015), "Recovery and resolution of central counterparties (CCPs)", Discussion paper for Member States’ experts meeting, 30 September
European Council (2014), Regulation (EU) No 909/2014 of the European Parliament and of the Countil on improving securities settlement in the European Union and on central securities depositories and amending Directives 98/26/EC and 2014/65/EU and Regulation (EU) No 236/2012.
Financial Stability Board (2014), Key Attributes of Effective Resolution Regimes for Financial Institutions
Gracie, A (2015), "CCP resolution and the ending Too Big to Fail agenda", speech given at 21st Annual Risk USA Conference, New York, 22 October
Huertas, T F (2016). "Resolution of Financial Market Infrastructures", 2nd interim report, CEPS Resolution Task Force
Tucker, P (2013), "Central counterparties in evolving capital markets: safety, recovery and resolution", Banque de France Financial Stability Review, 179 - 184
 Theoretically, if one FMI fails, market participants could shift to another or start a new one. That could be enough to create continuity. Practically, however, such substitutability is extremely difficult to achieve, particularly under stressed market conditions and within the compressed time frame necessary to maintain financial stability.