Financial Stability Paper No. 37
By Jo Braithwaite and David Murphy
Central clearing offers numerous benefits to financial stability including multilateral netting of cleared exposures and the centralisation of default management. These benefits explain the pivotal role of central counterparties (‘CCPs’) in the post-crisis derivatives market reforms. However they lead to a key financial stability question: will CCPs be able to manage a large member default effectively?
There are various aspects to this question, and we concentrate on one of the least studied: the legal certainty of CCP default management practices. This aspect is important because the prospect of legal challenge to a CCP could be destabilizing, and the legal framework within which CCPs operate is a complex and, in some areas, newly constructed one.
We evaluate the diverse legal rules governing CCP default management by investigating the extent to which they provide adequate legal certainty. The paper discusses the processes of clearing and collateral posting in detail, establishing the nature of the rights which CCPs rely upon when managing defaulting members. We then consider the relationship between CCP default management processes and insolvency law, as defaulting members are sometimes (but not always) insolvent. This leads to an evaluation of the legal issues arising along a typical default timeline of default declaration; returning to a matched book; and use of the defaulter’s collateral.
Our findings are that English and EU law provide legal certainty for many aspects of CCPs’ default management processes, but some challenges remain. One set arise through the piecemeal nature of the legislative framework, while others turn on the importance of CCPs’ contractual drafting being as robust as possible. The paper concludes with recommendations on both legislative and drafting issues.
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