Supervisory Stress Testing of Central Counterparties

Discussion Paper
Published on 21 June 2021

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Email: CCP-SST@bankofengland.co.uk

Foreword

The origins of modern central counterparties (CCPs) go back to around 1770, when London’s bank clerks first began gathering in the Five Bells Tavern on Lombard Street – just a short walk from the Bank of England – to exchange cheques and settle balances between themselves. The development of clearing houses for commodities futures at US exchanges later developed further the use of clearing infrastructures.

The fundamental concept of clearing – the facilitation of the exchange of payments, securities, or derivatives transactions and the reduction in the risk of a party failing to meet its obligations – has not changed much since then. But CCPs have become increasingly global and interconnected, and are now critical nodes in the financial system.

In many ways this was intended and a deliberate consequence of international reforms made following the Global Financial Crisis. CCPs can enhance the resilience of the financial system by simplifying financial interconnections, and ensuring transactions are more efficient, secure and transparent than if they were to take place bilaterally. But at the same time, due to this increasing central role in the financial system and the reliance that CCPs’ members place on them, this means that disruptions at CCPs now have greater potential to lead to stress in the wider financial system.

The Bank’s mission is to promote the good of the people of the United Kingdom by maintaining monetary and financial stability. The supervision of UK CCPs has been a central part of this mission since responsibility for CCP supervision transferred to the Bank of England in 2013.

In order to supervise CCPs effectively, the Bank needs the right high quality tools in its toolbox. As previously set out in the Bank’s Annual Report on the Supervision of Financial Market Infrastructures 2020, the Bank has been steadily developing CCP supervisory stress testing, and is working towards the publication of a supervisory stress-testing regime for UK CCPs.

The publication of this Discussion Paper is an important step towards the finalisation and publication of the CCP supervisory stress-testing regime. This Discussion Paper sets out a number of proposals and design issues for a CCP supervisory stress-testing framework that need careful consideration individually and collectively. For this reason, I encourage anyone with an interest or stake in this important topic to respond to the Bank on the questions raised in this paper.

CCP supervisory stress testing has potential to significantly enhance the Bank’s toolbox. Your responses will help the Bank to develop the best tool possible, and deploy it in the right way.

Sir Jon Cunliffe

Deputy Governor Financial Stability

Executive summary

Reflecting the growing importance of central counterparties (CCPs) and central clearing for UK financial stability, the Bank has in recent years been developing its approach to supervisory stress testing of CCPs. CCP supervisory stress testing has potential as a valuable tool to assist the Bank’s supervision and regulation of CCPs, and the attainment of the Bank’s broader financial stability objectives. Reflecting this, the Bank’s 2020 Annual Report on the Supervision of Financial Market Infrastructures noted the Bank’s intention to develop and publish a regime for CCP supervisory stress testing in the UK.

In recent years the Bank has already been closely involved with the development of the CPMI-IOSCO international framework for supervisory stress testing of CCPs, and in 2019 the Bank undertook a pilot CCP supervisory stress-test exercise with UK CCPs. To advance the development of the Bank’s regime for CCP supervisory stress testing further, the Bank is launching an exploratory CCP supervisory stress test in 2021 and, through this Discussion Paper, is seeking feedback on its proposals to develop a public framework for undertaking supervisory stress testing of CCPs in the UK.

The Bank intends to use CCP supervisory stress testing as a key mechanism through which to undertake assessments of the resilience of individual CCPs, and assessments of the broader resilience of the clearing network and its interactions with the rest of the financial system. CCP supervisory stress tests will also be used to promote transparency and help establish public confidence in the UK CCP system, helping to provide information to market participants and acting as a mechanism through which the Bank can be held accountable on its financial stability objective.

This Discussion Paper sets out a range of proposals and options for the design of the Bank’s CCP supervisory stress-testing framework across eight components of CCP supervisory stress testing, and considers how those design options might contribute to the Bank’s objectives.

For a number of these components, the Bank already has clear proposals and a direction of travel in mind. For example, the Bank proposes to use supervisory stress testing to assess both credit risk and liquidity risk in full. Analysis of credit and liquidity risk will also be undertaken using a combination of Bank and CCPs’ own analysis. In particular, CCPs will be responsible for extrapolating risk factor shocks provided to them, and then calculating the profit and losses on accounts, stressed cash inflows and outflows, and the value of collateral held. Meanwhile the Bank will provide risk factor shocks and – using information provided by CCPs on financial resource access, composition and usage – will apply default scenarios and undertake further analysis using its own models and methodology to generate results. The Bank also intends that supervisory stress tests are undertaken on an annual cycle, with the clearing services of all three CCPs authorised in the UK in scope.

For other components, the Bank is considering a broader range of options. Supervisory stress tests can be used to explore a range of alternative market stress scenarios, across different reference dates. The Bank considers that the most appropriate approach to scenario design is likely to differ according to the emphasis the Bank places on its different objectives within each individual supervisory stress test. While the Bank therefore proposes to maintain a degree of flexibility in the number, severity and design of market shock scenarios, and the selection of reference dates, it also welcomes feedback on the potential benefits of adopting standardised scenarios, on using consistent underlying methodology to select risk factors and generate risk factor shocks, and on the characteristics of reference dates that it should seek to examine.

Supervisory stress tests can also be used to explore the impact of a range of alternative default assumptions which could be equally or more plausible than the default of the Cover-2 population. Undertaking analysis of these alternative default assumptions will help the Bank better assess individual and system-wide CCP resilience, and examine the prudence of the Cover-2 standard to different populations of defaulters, and so the Bank welcomes feedback on the most insightful defaulter profiles to examine through supervisory stress testing.

The Bank also intends to use sensitivity and reverse stress testing when undertaking supervisory stress tests. While the exact approach taken to these components could differ between tests, including in response to feedback to this Discussion Paper, the Bank considers that these components will enable the Bank to examine the impact of deviations in its assumptions, and to identify combinations of assumptions that deplete CCP resources beyond normally acceptable levels.

The Bank intends to use the results from CCP supervisory stress testing to assess CCPs’ resilience across multiple dimensions of risk which, collectively and across individual supervisory stress tests, will be representative of the Bank’s risk tolerance for CCPs. In the initial years, the Bank intends for CCP stress-testing to be holistic and exploratory, rather than a pass-fail assessment.

Outcomes from CCP supervisory stress tests will be publicly disclosed to support the credibility and transparency of supervisory stress-testing exercises. Outcomes will also be used to inform and support the Bank’s supervisory and regulatory actions in both the short and long term. Given CCP supervisory stress tests inherently involve firm-specific, non-public information, the Bank’s approach to disclosure will be balanced against the need to protect sensitive data and avoid market impacts.

The Bank welcomes feedback on the proposals, options and discussion questions raised in this Discussion Paper from a broad range of stakeholders including CCPs, clearing members, wider market participants, supervisory authorities, academics, central banks and other relevant authorities.

The feedback received will be used in conjunction with the findings from running the Bank’s first public CCP supervisory stress test in 2021–22 to inform the further development of the Bank’s CCP supervisory stress-testing framework before the Bank’s final framework is published in due course.

1: Overview

Supervisory stress testing of central counterparties (CCPs) has the potential to support the Bank of England’s supervision and regulation of CCPs. As noted in ‘The Bank of England’s supervision of financial market infrastructures – Annual Report 2020’ (FMI Supervision Annual Report 2020), the Bank therefore intends to develop and publish a regime for CCP supervisory stress testing in the UK.

The Bank has developed its approach to CCP supervisory stress testing on a step-by-step basis. The Bank first co-chaired a CPMI-IOSCO sub-group to develop an international framework for supervisory stress testing for CCPs, which was published in 2018. In 2019, the Bank ran a ‘pilot stress-test exercise’ with UK CCPs to better understand the relevant data requirements and analytical processes for undertaking CCP supervisory stress tests. The Bank has also continued to engage with the European Securities and Markets Authority’s (ESMA) CCP supervisory stress tests, including as a National Competent Authority in the EU until 2020.

Further to these efforts, the Bank’s FMI Supervision Annual Report 2020 noted the Bank’s intentions to undertake its first public supervisory stress test of CCPs, and undertake further internal work to develop its approach to CCP supervisory stress testing prior to finalising and publishing the Bank’s supervisory stress-testing regime.

The Bank will launch its first public CCP supervisory stress in 2021, concluding in 2022. This exploratory exercise will be used to assess the credit and liquidity resilience of UK CCPs, and will help inform the further development of the Bank’s CCP supervisory stress-testing regime. This exercise is exploratory in nature and feedback to this Discussion Paper will not affect how the Bank undertakes this exercise.

In conjunction, the Bank is also publishing this Discussion Paper with the purpose of generating discussion and seeking feedback on the appropriate design of the Bank's regime for the supervisory stress testing of central counterparties. This Discussion Paper sets out a range of options and proposals for the design of the Bank’s CCP supervisory stress-testing regime, and how those design options might contribute to the Bank’s objectives for CCP supervisory stress testing. The Bank welcomes feedback on these options and proposals from a broad range of stakeholders, including CCPs, clearing members, wider market participants, supervisory authorities, academics, central banks and other relevant authorities. In combination with the findings from running the 2021–22 CCP stress-test exercise, this feedback will be used to inform the development of the Bank’s CCP supervisory stress-testing regime.

Following the completion of the Bank’s 2021–22 CCP supervisory stress test, and receipt of feedback to this Discussion Paper, the Bank intends to publish its final CCP supervisory stress-testing regime in due course.

The rest of this Discussion Paper is structured as follows:

  • Section 2 provides a general introduction to CCPs and their own stress testing, to help set the context and motivation for supervisory stress testing of CCPs.
  • Section 3 introduces the concept of CCP supervisory stress testing and outlines the Bank’s objectives for CCP supervisory stress testing.
  • Section 4 considers potential design options for CCP supervisory stress-testing frameworks and how these might help the Bank achieve its objectives for CCP supervisory stress testing. This section also sets out some details on the design of the Bank’s exploratory 2021–22 CCP supervisory stress test.
  • Section 5 outlines a series of discussion questions on the design of the Bank’s CCP supervisory stress-testing regime on which the Bank particularly welcomes feedback, and provides details on how to respond to this Discussion Paper.

Figure 1: The Bank’s approach to the development of a CCP SST regime

Figure 1 illustrates the steps that have, and will be, taken in the development of the Bank’s CCP supervisory stress testing regime.

Footnotes

  • Source: Bank of England.

2: Introduction to CCPs

Key points:

  • CCPs lie at the heart of the financial system, playing a crucial role in the functioning of financial markets.
  • CCPs provide efficiency and risk reduction benefits through the process of multilateral netting, risk mutualisation and their default management procedures.
  • CCPs have grown to become a critical node in the financial system; having the appropriate risk management arrangements in place at CCPs is therefore critical for financial stability.
  • Stress testing has long been a core component of CCPs’ own risk management. CCPs use stress testing to inform the level and type of financial resources they maintain and to assess the adequacy of those resources.

2.1: What are CCPs?

Financial market infrastructures (FMIs) such as CCPs lie at the heart of the financial system, providing crucial functions that help the economy and financial markets operate.

CCPs in particular play an important role in reducing counterparty credit risk in the financial system. This is the risk that one party to a financial market trade defaults on its obligations to the counterparty on the other side of that same trade. When a trade is not cleared through a CCP, then the default of a party on either side of that trade can result in financial distress for both parties. That can have potential knock-on effects for their other trades and counterparties, and even the rest of the financial system. When a trade is cleared through a CCP, that CCP can act as a ‘circuit breaker’ in the event of a default, reducing the risk of contagion through financial markets.

CCPs reduce counterparty credit risk through two main functions. First, CCPs provide for the reduction in the size of exposures in the financial system. Through a process known as multilateral netting – and as demonstrated in Figure 2 – CCPs can offset amounts owed between their clearing members. This also acts to reduce total collateral and liquidity needs for clearing members.

Figure 2: Multilateral netting at CCPs

Figure 2 provides an illustration of the benefits of multilateral netting, comparing three types of trades: non-cleared bilateral trades, gross exposures of cleared trades, and net exposures of cleared trades.

Footnotes

  • Source: Bank of England.

Second, CCPs have arrangements in place to manage the potential default of their clearing members in an orderly way. As also demonstrated in Figure 2, clearing members no longer maintain a direct exposure to other clearing members when they clear trades through a CCP. Instead, the CCP takes on these exposures and has resources, rules and arrangements to manage them in the event of a clearing member default.

These rules and arrangements typically include looking to auction off the positions of defaulting clearing members to non-defaulting clearing members in order to return the CCP to a matched book, and CCPs using their financial resources to hedge the positions of defaulting clearing members in the interim period ahead of these auctions.

The financial resources available to CCPs include collateral posted by clearing members against their trades (known as initial margin), and a default fund (DF) into which all of a CCP’s clearing members make contributions. CCPs also hold some of their own capital against default risk, and have powers to call additional unfunded resources from their clearing members. Collectively these resources are known as the Default Waterfall (Figure 3), and they can be drawn on by the CCP to meet the obligations of defaulting clearing members to non-defaulting clearing members. The sequence in which the available resources in the Default Waterfall are used in the event of a clearing member default helps create incentives for both clearing members and the CCP itself to manage the risks they take on. For example, the initial margin and default fund (DF) contributions of a defaulting clearing member (known as defaulter resources) are drawn down before CCP and non-defaulting clearing member resources.

Figure 3: An Illustrative CCP Default Waterfall

Figure 3 illustrates a CCP default waterfall, and the various layers of this default waterfall. Defaulter resources consist of margin collateral and contributions of a defaulter to the default fund. CCP sand surviving member resources consist of CCP skin in the game, non-defaulters contributions, assessments, and other loss allocation arrangements.

Footnotes

  • Source: Bank of England.

2.2: Why are CCPs important for financial stability?

In the years following the global financial crisis of 2007–08, the G20 introduced global financial market reforms designed to increase the use of central clearing. These reforms enhanced financial stability by simplifying the network of counterparty exposures between financial institutions, and reducing the aggregate size of these exposures. In achieving this objective, CCPs have become increasingly interconnected with their clearing members, liquidity providers, custodians and other financial institutions.

As a result, CCPs have also become increasingly important for financial stability and a critical node in the financial system. Actions taken by CCPs during their normal course of business, during market stress, or in the event of a clearing member default all have the potential to have significant impacts on other parts of the financial system and market participants.

For example, CCP margin calls are critical to reduce and mitigate counterparty credit risk in the financial system. This reduction in counterparty credit risk is a major accomplishment of the post 2007-08 reforms. However, margin calls also create liquidity demands on clearing members and clients and could, if abrupt or severe, be destabilising during periods of market stress. Clearing members and clients who face large and unexpected margin calls might have to liquidate positions or attempt to access other sources of funding in illiquid markets at short notice in order to meet these margin calls. In periods of market stress, this can exacerbate volatility in markets.

In the event of clearing member default(s), non-defaulting clearing members’ resources in a CCP’s default waterfall are at risk of depletion. CCPs might also be forced to call additional resources from non-defaulting clearing members if their initial contributions to the Default Waterfall are depleted. Likewise, without sufficient liquid resources, or as a result of the failure of a liquidity provider, a CCP’s ability to meet its obligations to clearing members (such as the payment of variation margin) might be impeded.

Due to this increasing importance of CCPs in recent years, work to strengthen individual CCPs’ financial resilience and ensure that they support financial stability in the markets in which they operate has continued at both at the domestic and international level. For example, in 2012 CPMI & IOSCO published the Principles for Financial Market Infrastructures (PFMI), which strengthened and harmonised pre-existing international standards for financial market infrastructures by raising minimum standards, providing more detailed guidance, and broadening the scope of the standards to cover new risk areas. Among other things, the PFMI set expectations that CCPs would maintain a high level of financial resources to address the types of credit and liquidity risks described above. Further guidance on the PFMI regarding the resilience of CCPs was published in 2017, focusing on five key aspects of CCP’s financial risk management framework: governance, stress testing for both credit and liquidity exposures, coverage, margin, and a CCP’s contribution of its financial resources to losses.

2.3: What is CCP stress testing?

Stress testing has long been a core risk management tool for CCPs. It is primarily used for financial and liquidity resource sizing, and to help CCPs identify potentially material impacts of tail risk events on their clearing members’ exposures. The PFMI and UK domestic legislation in fact set firm expectations and requirements that CCPs perform their own daily stress tests to size, and assess the sufficiency of, financial resources from both a credit and liquidity perspective.

As noted in Section 2.1, the financial resources held by CCPs are made up of different components. Initial margin is the first line of defence against credit losses that might arise from a clearing member default, and CCPs are required to hold initial margin to cover potential losses to at least a 99% level of confidence.

CCPs are also required to hold additional resources to cover potential losses that might exceed initial margin in ‘extreme but plausible’ scenarios. In particular, in the UK, CCPs are required to hold adequate resources to cover at least the largest aggregate credit exposures (ie losses over initial margin) in the event that two clearing members default in an extreme but plausible market scenario. This is commonly known as the Cover-2 standard for credit.

CCPs use stress testing to examine a range of market stress scenarios that capture extreme but plausible market conditions, in order to size and test the adequacy of the financial resources they hold to meet this Cover-2 standard. In order to be extreme, market scenarios will normally be representative of observed market movements or synthetic shocks that are sufficiently outside of normal market conditions. In order to be plausible, those same market scenarios should also represent realistic market movements and resulting participant losses, based on current market conditions, regardless of whether the scenarios are historical or hypothetical.

As with financial resource sizing, CCPs also deploy stress testing to determine and assess the sufficiency of their liquid resources. In particular, the liquidity Cover-2 standard requires that CCPs hold sufficient liquid resources to meet liquidity requirements under stressed liquidity needs, assuming the default of at least the two clearing members to which a CCP has the largest exposures under extreme but plausible market conditions. This standard applies across each relevant currency, requiring CCPs to take into account the currencies in which their liabilities are denominated and their ability to access foreign exchange markets in stressed conditions.

Figure 4: An illustration of CCP financial resource requirements

Figure 4 illustrates how CCP’s financial resource requirements - and the components of these requirements - are sized and combine with each other.

Footnotes

  • Source: Bank of England.

3: Purpose and objectives of CCP supervisory stress testing

Key points:

  • Reflecting the growing importance of CCPs and central clearing, international and domestic efforts have turned to the development of CCP supervisory stress tests in recent years.
  • Supervisory stress testing can play a complementary role to CCPs’ own stress testing, helping authorities to assess alternative market stress and clearing member default scenarios, as well as the linkages, dependencies and resilience within the wider clearing system.
  • The Bank intends to use CCP supervisory stress testing to assess individual CCP resilience, the system-wide resilience of CCPs, and the interactions of CCPs with the rest of the financial system.
  • The flexibility of CCP supervisory stress testing, and the range of purposes with which it can be deployed, makes it a valuable tool for the Bank in its pursuit of these objectives.
  • The Bank intends to use the results from CCP supervisory stress testing to assess CCPs’ resilience across multiple dimensions of risk which, collectively and across individual supervisory stress tests, will be representative of the Bank’s risk tolerance for CCPs.

3.1: The case for CCP supervisory stress testing

In recent years, international and domestic efforts have turned to the development of CCP supervisory stress tests – designed and executed by authorities – as a potential tool to complement CCPs’ own stress tests (Box A).

An important driver of these efforts are the benefits that CCP supervisory stress testing can provide to authorities above and beyond those provided by the daily stress tests that CCPs undertake themselves. While CCPs’ own stress tests are predominantly (though not solely) designed to test individual CCPs against minimum Cover-2 standards, CCP supervisory stress tests can incorporate a greater degree of flexibility in how they are used to assess individual and system-wide CCP resilience.

CCP supervisory stress tests can be used to complement CCPs’ own assessment of their individual resilience. For example, CCP supervisory stress testing could be used to examine the impact of alternative market stresses that might be of particular interest to the Bank. They could also be used to explore the default of an alternative population of clearing members or liquidity providers, including those that could have an equal or greater impact on CCPs than the default of the Cover-2 population.

While CCPs’ daily stress tests focus on their own individual risk management, clearing markets and products cleared, CCP supervisory stress tests can also be used to take a system-wide view. CCP supervisory stress tests are therefore better suited to capture and assess the linkages, dependencies and shared risk factors between CCPs, their members and service providers. As a result, they are well placed to inform the Bank’s understanding of the impacts that could materialise if CCPs were to face a common stress event, and the resilience of CCPs in such events.

Supervisory stress tests can also be used to assess interactions between CCPs and the rest of the financial system. For example, they could be used to examine the impacts of stresses on non-defaulting clearing members in a common default event, or the impact of the loss sharing mechanisms of CCPs on non-defaulting clearing members.

CCP supervisory stress tests therefore have potential as a valuable supervisory tool for the Bank.

3.2: Objectives of Bank of England CCP supervisory stress testing

As the authority responsible for the supervision of financial market infrastructure firms (FMIs) in the UK, the Bank seeks to ensure that CCPs have robust systems, processes and financial resources in place to withstand extreme market events. As part of its broader mission to maintain financial stability in the UK, the Bank also seeks to ensure that the CCPs it regulates reduce systemic risk by avoiding disruption to the clearing services they provide, and avoid behaviours that have an adverse impact on the safety and soundness of their members (subject to preserving their own resilience). Reflecting these objectives, the Bank intends to use CCP supervisory stress testing to assess both individual and system-wide CCP resilience.

The Bank also intends to use CCP supervisory stress testing to promote transparency and establish public confidence in the UK CCP system. In particular, the Bank intends that CCP supervisory stress tests be used to (i) demonstrate the range of severe stresses to which the Bank expects CCPs to be resilient, (ii) provide information on the performance of CCPs to market participants, and (iii) provide a mechanism through which the Bank can be held accountable to Parliament and the wider public on its financial stability objective.

The Bank of England’s objectives for CCP supervisory stress testing:

1. Test individual CCP resilience.

2. Explore system-wide CCP resilience and interactions with the rest of the financial system.

3. Promote transparency and establish public confidence in the UK CCP system.

Supervisory stress testing of CCPs will provide particular value to the Bank in its pursuit of these objectives in part due to the significant degree of flexibility with which it can be deployed. As illustrated in Table A below, individual supervisory stress tests can be designed with a range of purposes or questions in mind. For example, they could be used to assess whether individual CCPs have sufficient financial and liquidity resources to withstand certain market stresses and clearing member defaults (including market stress and defaulter assumptions not covered in CCPs own stress tests). They could also be used to examine the scope and magnitude of the interdependencies between CCPs, markets and other entities (such as concentrations of exposures to common participants, common risk factors or common dependencies on particular liquidity providers or other service providers).

The Bank therefore intends to use the results from CCP supervisory stress testing to assess CCPs’ resilience across multiple dimensions of risk which, collectively and across individual supervisory stress tests, will be representative of the Bank’s risk tolerance for CCPs. While the precise calibration of the Bank’s response to supervisory stress-testing results will be determined by the nature of the potential weaknesses and vulnerabilities identified, the Bank considers that the general purposes for which supervisory stress-test results will be used, outlined below, will ensure the Bank and CCPs take appropriate actions to remedy any deficiencies identified through the supervisory stress testing process:

  1. To inform supervisory expectations – supervisory stress-test results will be used to inform the Bank’s expectations on CCPs’ risk management and whether those expectations are met.
  2. To inform and specify supervisory and regulatory actions – supervisory stress-test results will be used to inform and specify supervisory and regulatory actions, whether this be focused on an individual CCP, a sub-set of CCPs, all CCPs, or other parts of the financial system. This includes informing the calibration of existing requirements, or the development of additional policies.
  3. To assist the monitoring of risks – supervisory stress-test results will be used to monitor systemic risks, and may be used to trigger heightened monitoring in some areas.

Table A: Illustrative purposes of individual CCP supervisory stress tests

Examination of individual CCP resilience

Examination of system-wide CCP resilience and financial system interactions

Credit risk

Do individual CCPs have sufficient prefunded financial resources to withstand the default of a given population of clearing members under stressed market conditions?

Do individual CCPs have sufficient powers of assessment beyond pre-funded financial resources to withstand the default of a given population of clearing members under stressed market conditions?

Which risk factor shocks or stress scenarios are likely to generate the largest losses at individual CCPs?

What profile of clearing member defaults would exhaust the largest share of pre-funded resources across all CCPs under stressed market conditions?

What additional financial resources would CCPs collectively require from non-defaulting clearing members in the event of a common market shock and default event? Would the non-defaulting clearing members be able to meet these demands?

Which market stress scenarios would generate the largest cumulative losses across CCPs? What would be the distribution of losses?

Liquidity risk

Do individual CCPs have sufficient liquidity resources to meet their liquidity needs upon the default of a given population of clearing members under stressed market conditions?

What is the impact on individual CCPs’ ability to meet its liquidity demands if a liquidity provider fails to meet its obligations to the CCP?

Which risk factor shocks or stress scenarios are likely to generate the largest liquidity demands at individual CCPs?

What is the total cash by currency that will be simultaneously demanded by CCPs from common liquidity providers under stressed market conditions?

What is the cumulative size of market transactions by asset class that CCPs are relying on to meet liquidity needs under a common stress scenario?

Which common liquidity provider’s failure would have most impact across CCPs, under a given market stress and/or profile of clearing member defaults?

The following section of this Discussion Paper (Section 4) considers in more detail how different options for the design of CCP supervisory stress tests could help the Bank meet its objectives for CCP supervisory stress testing. The Bank is particularly keen to receive feedback on these options, and how they can best contribute to the achievement of the Bank’s objectives for CCP supervisory stress testing.

Box A: International approaches to CCP supervisory stress testing

In recent years, there has been increased interest in the development of supervisory stress-testing frameworks for CCPs, both at national and international level.

In 2018, two international standard setting bodies – the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) – jointly published the CPMI-IOSCO Framework for Supervisory Stress Testing of Central Counterparties.

The framework is intended to support CCP stress tests conducted by authorities with the aim of examining the potential macro-level impact of a common stress event affecting multiple CCPs.

Other national authorities have also developed approaches for CCP supervisory stress testing in recent years.

The US Commodity Future Trading Commission (CFTC) – which regulates the US derivatives market – has undertaken three public supervisory stress tests.

  • The first, a Supervisory Stress Test of Clearinghouses, was published in November 2016. This test studied the impact of a set of stressed market conditions and defaults across multiple CCPs, with a focus on firms that held memberships at more than one CCP.
  • In 2017, the CFTC published its second SST, an Evaluation of Clearinghouse Liquidity. This report evaluated how CCPs would seek to obtain, in a timely manner, the funds necessary to meet the settlement obligations arising from the simultaneous default of two large clearing members, and whether the need for multiple CCPs to generate liquidity funding simultaneously had any systemic implications.
  • The CFTC’s most recent SST, published in 2019, comprised two sections. First, a reverse stress test of CCP resources in order to identify potentially implausible scenarios extreme enough to exhaust all pre-funded resources available to CCPs. Second, an analysis of stressed liquidation costs to evaluate whether CCPs had sufficient pre-funded resources to meet both the payment obligations resulting from a house account default concurrent with an extreme market move, as well as greater than expected costs resulting from hedging and auctioning the positions of the defaulting clearing member.

The European Securities and Markets Authority (ESMA) – an independent EU Authority responsible for enhancing the protection of investors and promoting stable and orderly financial markets – has also undertaken three public EU-wide supervisory stress tests (below), and launched its fourth exercise in June 2021.

  • ESMA’s first stress test, published in 2016, was focused on the counterparty credit risk that CCPs would face as a result of multiple clearing member defaults and simultaneous market price shocks. This was also complemented with an analysis of the concentration of CCPs’ exposures and of the potential spill-over effects to non-defaulting clearing members, by assessing the likelihood of additional defaults triggered by the loss absorption mechanism of CCPs.
  • ESMA’s second stress test, published in 2018, expanded on ESMA’s first stress test by focussing on liquidity risks – examining whether CCPs would meet their liquidity needs under different stress scenarios – in addition to an examination of counterparty credit risk.
  • In 2020 ESMA published its third stress test covering credit and liquidity risk, and extended the methodology of previous ESMA supervisory stress tests further by including a new concentration risk component, that was used to assess the losses arising from the costs of liquidating concentrated positions.

4: Key components of the Bank’s CCP supervisory stress-testing framework

Key points:

  • The Bank’s framework for CCP supervisory stress testing will consist of eight individual but interrelated components. These components include those where the Bank has a clear proposal or direction of travel on which it is seeking specific feedback, and components where there are a broader range of options the Bank is considering and on which it welcomes feedback.
  • The Bank intends to use supervisory stress testing to assess both credit risk and liquidity risk in full. Analysis of credit and liquidity risk will be undertaken using a combination of Bank and CCP models and analysis, with CCPs responsible for extrapolating core risk factors and reporting account profit and loss, cash flows, and data on financial and liquidity resource availability.
  • It is anticipated that supervisory stress tests will be undertaken on an annual cycle with an expected exercise duration of nine months. The clearing services of all three UK CCPs will be in scope.
  • Supervisory stress tests can be used to explore a range of alternative market stress scenarios, and the most appropriate approach to scenario design is likely to differ according to the emphasis the Bank places on its different objectives in each individual supervisory stress test. While the Bank therefore proposes to maintain a degree of flexibility in the number, severity and design of market shock scenarios, there may be benefits in adopting standardised scenarios over time, or using a consistent underlying methodology to select risk factors and generate risk factor shocks. Standardised scenarios could also be used to independently examine the adequacy of CCPs financial resources against the Cover-2 standard.
  • The Bank intends to examine market scenarios using representative reference dates, though proposes to maintain flexibility to adjust its approach between individual supervisory stress tests.
  • Supervisory stress tests can also be used to explore the impact of a range of alternative default assumptions that could be equally or more plausible than the default of the Cover-2 population. Undertaking analysis of these alternative default assumptions will help the Bank better assess individual and system-wide CCP resilience, and examine the prudence of the Cover-2 standard to different populations of defaulters.
  • The Bank intends to use sensitivity analysis and reverse stress testing when undertaking supervisory stress tests. This will enable the Bank to examine the impact of deviations in its assumptions, and identify combinations of assumptions that deplete CCP resources beyond normally acceptable levels.
  • Results from CCP supervisory stress tests will be publicly disclosed and used to inform and support the Bank’s supervisory and regulatory actions. Results will need to be assessed against a set of clear, understandable and robust metrics. Given CCP supervisory stress tests inherently involve firm-specific, non-public information, the Bank’s approach to disclosure will also be balanced against the need to protect sensitive data and avoid market impacts.
  • The Bank welcomes feedback on the proposals and options set out for each of the components of its CCP supervisory stress-testing framework. This feedback will be used in conjunction with the findings from running the Bank’s first public CCP supervisory stress test in 2021–22 to inform the development of the Bank’s CCP supervisory stress-testing framework. The Bank’s 2021–22 CCP supervisory stress test will be exploratory in nature, and will not be affected by feedback to this Discussion Paper.

This section of the Discussion Paper considers potential design options for eight individual but interrelated components of the Bank’s supervisory stress-testing framework (illustrated in Table B).

In considering these components, a broad distinction can be made between components 4.1–4.3 where the Bank has a clear proposal or direction of travel, and components 4.4–4.8 where there are a broader range of options the Bank is considering.

As detailed further in this section, the Bank has already identified preferred approaches and proposals relating to the risk coverage of supervisory stress tests, the methodology with which they are undertaken, their frequency, and participation in them (components 4.1–4.3). For each of these components, the Bank is seeking feedback on specific parts of its proposals through this Discussion Paper.

For components 4.4–4.8, this section outlines a broader range of options the Bank is considering. As detailed further in this section, each of the options considered in these components – individually and collectively – could contribute to the Bank’s objectives in different ways. The application of some of these components could also vary over time, as the specific emphasis of individual supervisory stress tests is adjusted between iterations. The Bank therefore welcomes external feedback on the options outlined in these sections, and how they might provide value to the respondents to this Discussion Paper.

For each of the components 4.1–4.8 above, this section also sets out discussion questions on which external feedback would be most valuable for the Bank. These discussion questions are summarised in Section 5 of this Discussion Paper.

Box B in this section sets out some high level details of how the Bank intends to apply these components to its first public CCP supervisory stress test, which will be launched in 2021. As noted in Section 1, this exercise will be exploratory in nature and the findings from running the exercise will be used to help inform the further development of the Bank’s CCP supervisory stress-testing framework. The Bank is not seeking feedback on the design of this test through this Discussion Paper.

Box C highlights some key differences between banking system supervisory stress tests and CCP supervisory stress tests, and the importance of CCP supervisory stress tests being designed to reflect these differences.

Table B: The eight components of the Bank of England’s CCP supervisory stress-testing framework

Components

Proposed approach (4.1–4.3)

4.1: Risk coverage and participation

4.2: Frequency and timings

4.3: Methodology

Options for consideration (4.4–4.8)

4.4: Market shock scenarios

4.5: Reference rates

4.6: Defaulter assumptions

4.7: Sensitivity and reverse stress testing

4.8: Disclosure

Footnotes

  • Source: Bank of England.

4.1: Risk coverage and participation

Risk coverage

In order to best meet its objectives to assess the resilience of individual and system-wide CCP resilience, the Bank proposes that its supervisory stress tests will be used to assess both credit risk and liquidity risk.

Through the application of credit-risk analysis, the Bank will be able to assess the sufficiency of CCPs’ resources under combined market stress and clearing member default scenarios, examine the potential losses they might make, and the mutualised losses that may need to be covered by clearing participants. Credit risk will be assessed in full, including an examination of liquidity cost impacts of concentrated positions (ie concentration risk). Concentration risk is the added cost of liquidating concentrated positions in the market in a short amount of time. By examining concentration risk, the Bank will be able to assess the costs that CCPs are likely to incur beyond mid-market prices, and how these costs might be affected by the size of a defaulting members’ positions and the depth of the financial markets in which they operate.

Through liquidity stress testing, the Bank will be able to assess the sufficiency and availability of CCPs’ liquid resources under combined market stress and clearing member and/or liquidity provider default scenarios, examine potential liquidity outflows, and potential liquidity calls to and from clearing participants and other parties. In examining liquidity risk, the Bank will assess a range of potential sources and channels. For example, supervisory stress testing can be used to assess the ability of CCPs to post variation margin to non-defaulting members, meet the settlement obligations of clearing members, and examine risks arising from the non-performance of liquidity and/or service providers. Liquidity stress testing will also be used to identify concentrations of collateral, similarities between CCPs’ approaches for generating liquidity, commonalities in CCPs’ relationships with liquidity and service providers, and how the price and liquidity of assets could evolve in an unanticipated way during stress events. As such, liquidity stress testing will capture both analysis of the resilience of individual CCPs as well as the systemic dimension of liquidity risk.

In the medium term, the Bank will also explore the potential of CCP supervisory stress testing as a tool for examining default-related operational risk – for example CCPs’ ability to manage, hedge and revalue portfolios in a stress. In general, CCPs have arrangements in place to ensure they are resilient to default risk, and arrangements in place to ensure they are resilient to operational risk events. Inclusion of default-related operational risk within the scope of CCP supervisory stress tests could help the Bank assess the impact of simultaneous default and operational risk events, including during periods of market stress, and help reveal how significant these issues are for individual and system-wide CCP resilience.

Participation

The ability of the Bank to undertake an assessment of the system-wide resilience of CCPs and the interaction of the clearing network with the rest of the financial system is likely to be enhanced as the number of CCPs and coverage of the clearing network increases. Likewise, the ability of the Bank to undertake a sufficiently thorough assessment of individual CCPs’ resilience is likely to be enhanced as more clearing services, products, currencies and markets are brought into scope of CCP supervisory stress tests. As such, supervisory stress tests with greater coverage would provide a more complete perspective of interconnections in the clearing system, the collective responses of CCPs to a common stress event, and the resilience of individual CCPs.

However, the Bank also recognises an inherent trade-off between the coverage of its CCP supervisory stress tests and the resource costs involved in running them. In particular, the greater the coverage of supervisory stress tests, the greater the resource cost for the Bank, and the higher the probability that supervisory stress tests place disproportionate costs on CCPs whose activities are likely to be less important for the overall findings of a stress test.

The Bank proposes that its supervisory stress tests cover the clearing services of the three CCPs that are authorised in the UK. The Bank will return to the question of the potential inclusion of any non-UK CCPs deemed systemic in the UK following the publication of its forthcoming approach to assessing the systemic importance and recognition of non-UK CCPs. Where participation in the Bank’s supervisory stress tests overlaps with that of other regulatory authorities, the Bank will ensure appropriate co-ordination and co-operation arrangements are in place.

Discussion questions:

1. Within the specified risk coverage, what specific risk exposures or areas should be prioritised for more granular analysis and disclosure?

2. Are there other risk exposures that supervisory stress testing would be the most optimal tool to assess from a regulatory perspective?

3. Should the Bank develop an approach for assessing default-related operational risks? If so, what methods could be deployed for assessing these risks?

4.2: Frequency and timings

There are a range of options as to how frequently the Bank could elect to undertake CCP supervisory stress tests. For example, stress tests could be taken as one-offs, on an ad-hoc basis, or take place at a pre-determined frequency (such an annually or biennially).

Naturally, supervisory stress tests that are undertaken more frequently are more likely to support the Bank’s assessment of the resilience of individual CCPs and the wider clearing system. Clearing members’ positions and CCPs’ exposures change over time, and long lags between stress tests could therefore result in their findings becoming quickly outdated. In addition, while individual tests can assist the Bank’s identification of risks and vulnerabilities at a particular point in time, tests that occur on a regular basis would enable the Bank to better monitor changes and developments over time.

On the other hand, undertaking supervisory stress tests at a too regular frequency is likely to be burdensome for both the Bank and other participants of the supervisory stress tests. Undertaking supervisory stress tests requires sophisticated analysis at both the Bank and CCPs, which might be less feasible over shorter periods. Without sufficient time between supervisory stress tests, it might also become more difficult to develop and embed modelling and analytical improvements over time.

The Bank therefore proposes to undertake CCP supervisory stress tests on an annual basis. While this is consistent with the frequency at which the Bank undertakes stress tests on other parts of the financial system, it also strikes the appropriate balance between delivering timely assessments of individual and system-wide CCP resilience and the resource costs involved in generating those assessments.

The Bank anticipates that each annual supervisory stress test will be run over a nine-month period. The Bank considers that this will enable enough time for the appropriate analysis and governance arrangements to be undertaken at both the Bank and in-scope CCPs, while also ensuring the findings of each exercise remain sufficiently up-to-date upon, and beyond, their publication.

Supervisory stress tests will typically be launched at the start of Q4 each year, concluding by end-Q2 the following year. This cycle would enable the Bank to align the publication of supervisory stress-test results with the publication of the Financial Policy Committee’s Q2 Financial Stability Reports, and reduce the volume of analysis required over the summer months. Figure 5 below provides an illustrative example of the stages of this nine-month CCP supervisory stress-testing cycle. The Bank anticipates that over time the proposed timelines for supervisory stress testing are likely to evolve, as the Bank continues to enhance its supervisory stress-testing capabilities.

Figure 5: Example timeline for CCP SST

Figure 5 illustrates an example timeline for a CCP supervisory stress test, as described in the preceding text.

Footnotes

  • Source: Bank of England.

Discussion question:

4. What are respondents’ views on the proposed launch and publication dates of the Bank’s CCP supervisory stress tests? Are there benefits to launching stress tests and publishing results at alternative dates?

4.3: Methodology

There are different approaches that could be taken regarding the balance of responsibility between the Bank and CCPs for undertaking the analysis for supervisory stress. At one end of the spectrum, the Bank could be responsible for collecting full granular position data and undertaking all of the analysis required in the supervisory stress test with its own valuation methodology. At the other end, the Bank could fully rely on CCPs after specifying market shock and default assumptions, or after specifying a common valuation methodology for CCPs to follow.

The Bank aims to strike a balance between these approaches, using a hybrid approach which draws on both CCPs proprietary models and modelling applied by the Bank (as detailed further below).

Credit stress testing

Credit stress testing will be undertaken through the combination of common market shocks provided by the Bank and extrapolated and applied by CCPs, member default scenarios applied by the Bank, and concentration cost and additional analysis undertaken by the Bank.

In particular, the Bank will provide reference dates for the stress test, and shocks across key risk factors for each scenario considered in the stress test. CCPs will be responsible for extrapolating these to other risk factors not provided by the Bank, and for reporting for each of their members (and for each reference date and scenario) the profit and loss the CCP would face at account level. When doing so, CCPs will be required to run a full re-pricing of portfolios for each market scenario provided by the Bank, and to revalue their collateral alongside the cleared products using the market stress scenario shocks. CCPs will be required to provide this information to the Bank alongside data on financial resource access, composition and usage.

The Bank will then apply the conditions and assumptions underlying the member default scenarios in order to identify the groups of clearing members that are assumed to be in default. The Bank will also layer on its own additional analysis including, but not limited to, analysis of concentration costs, before undertaking an examination of losses and generating aggregated results (as appropriate) for publication.

Liquidity stress testing

Liquidity stress testing will be undertaken through the combination of risk factor market shocks provided by the Bank and extrapolated by CCPs, the simultaneous default of market participants applied by the Bank, and additional analysis also undertaken by the Bank.

In particular, the Bank will provide reference dates for the stress test, and risk factor shocks for each scenario considered in the test. CCPs will again be responsible for extrapolating these to other risk factors not provided by the Bank, and then for calculating and providing stressed cash inflows and outflows over the duration of the stress test period. CCPs will be required to report the schedule of stressed flows arising from variation margin, premium settlements, IM change and settlement across each relevant currency.

The Bank will then apply the default of market participants and/or providers of liquidity services with an impact on the liquidity profile of an individual CCP, drawing from clearing members, issuers, custodians, payment banks and repo counterparties. The Bank will then undertake its analysis of projected cash flows, and layer on any additional analysis as appropriate, before generating aggregated results (as appropriate) for publication.

Undertaking stress testing in this way for both credit and liquidity risk will allow the Bank to utilise models readily available at CCPs for the purpose of stress testing, and avoid the resource costs and operational burdens associated with developing its own full modelling capacity from scratch. At the same time, it also avoids full reliance on CCPs models, in particular allowing the Bank to apply a broad range of assumptions to, and undertake a variety of analysis on, the data provided by CCPs.

In order to maintain a sufficient level of consistency between CCPs’ data returns for the purpose of supervisory stress testing, the Bank will also have in place measures to run validations and plausibility checks, review outputs, and understand key assumptions and methodologies applied by CCPs.

Discussion questions:

5. Are there areas or assumptions within the methodology as described in this Discussion Paper that respondents consider particularly important or insightful, and should be prioritised in the analysis and disclosure of results?

6. Are there specific vulnerabilities, dependencies or risk exposures of UK CCPs that respondents believe are not sufficiently covered by the methodology as described in this Discussion Paper?

4.4: Market shock scenarios

The flexibility provided by CCP supervisory stress testing enables the Bank to examine a range of alternative market shock scenarios. However, unlike CCPs who run a large number of market stress scenarios daily, the Bank only proposes to use a small number of scenarios in each supervisory stress test due to the resource costs and communication challenges involved with producing results across a large number of scenarios (see below).

This creates a natural challenge for the Bank. Different approaches to market scenario development are likely to be more or less suited to achieve the Bank’s individual objectives of assessing the resilience of individual CCPs, and examining system-wide CCP resilience and CCPs’ interactions with the rest of the financial system.

For example, CCPs often have very different exposures and in any given scenario, the magnitude of specific risk factor shocks will not necessarily be equally severe for all CCPs and their respective services. If the Bank was predominantly interested in making direct comparisons between individual CCPs’ resilience in a particular supervisory stress test, then an important aspect of stress-test design would therefore be designing a market shock scenario that had a broadly similar impact across CCPs. In system-wide focused tests in which the Bank is interested in exploring other vulnerabilities – such as the impact of a severe stress in certain risk factors and the propagation of that across the clearing system – this consideration is likely to be less important.

Overall, the Bank therefore proposes to maintain a degree of flexibility in its market shock scenario design for each individual supervisory stress test. In particular, market stress scenarios are likely to change depending on the emphasis of individual supervisory stress tests. However, the Bank also welcomes feedback on a number of aspects of market scenario design or scenario types that should be prioritised by the Bank for assessing the resilience of individual CCPs and/or system-wide CCP resilience and interactions with the rest of the financial system. As such, the following material considers potential underlying methodologies that could be adopted for scenario generation, the appropriate number of scenarios to deploy, the appropriate severity of market shock scenarios, the appropriateness of scenario standardisation over time, and the selection of risk factors for market shock scenarios.

Underlying methodology and severity of scenarios

There are a number of methodologies that could be deployed to generate market shock scenarios. There may be merit in adopting a broadly consistent underlying methodology to develop market shock scenarios across individual supervisory stress tests, including to reduce long-term resource costs for the Bank.

Some of these methodologies would be likely to generate scenarios to a similar severity as those observed historically, or the ‘extreme but plausible’ scenarios used by CCPs in their own stress testing. However, scenarios could also be calibrated to go beyond observed shocks, CCPs’ own extreme but plausible scenarios to test a higher level of resilience, or be calibrated to a given confidence level.

Potential approaches which the Bank will continue to consider further include:

  • Building market shocks from historical scenarios. The Bank could deploy scenarios that replicate historical events, or use market shocks sourced from them.
  • Building market shocks from CCPs’ own scenarios. The Bank could draw directly from scenarios used in CCPs’ own internal stress tests. For example, the Bank could use CCPs’ most severe scenarios as the basis for the common suite of scenarios applied to CCPs, suitably extrapolated and adjusted to ensure internal consistency.
  • Building hypothetical market shock scenarios. The Bank could deploy scenarios that are consistent with a series of market shocks which, while hypothetical, have a historical parallel. Alternatively, the Bank could deploy a hypothetical set of risk factor shocks based on expert judgement with reference to historically observed dependencies between risk factors. The Bank could also deploy shocks that are more novel in nature, such as shocks that incorporate breakdowns in the expected correlations between risk factors. These shocks could be equally or more severe in nature than shocks drawn from historical scenarios or CCP’s own stress-test scenarios.
  • Building market shock scenarios with an underlying empirical model. The Bank could build market shock scenarios with some underlying empirical methodology. For example, the Bank could develop and utilise a model that relies on the empirically observed probability distribution of risk factors individually and/or collectively to generate the nature and scale of observed market shocks. Such an approach could lend itself to standardisation over time, with scenario severity adjusting according individual risk factors location in the probability distribution. Again, these shocks could be equally or more severe in nature than shocks drawn from historical scenarios or CCPs’ own stress-test scenarios, or calibrated to a given confidence level.

Number of scenarios

Assessing CCPs against multiple scenarios could help to ensure that the Bank was not just assessing CCPs’ resilience against a single bad state of the world, and could enable the Bank to better achieve its objectives by assessing individual and system-wide CCP resilience against a broad range of shocks. By deploying multiple scenarios in each supervisory stress test, the Bank could simultaneously deploy scenarios designed to test individual CCP resilience and system-wide CCP resilience, respectively.

However, market stress scenarios would need to be sufficiently distinct so as to generate benefits for the Bank’s analysis. Further, there would be additional resource costs for both the Bank and the CCPs associated with running multiple scenarios. Sensitivity and reverse stress testing (Section 4.8) are also likely to be a more useful tool for generating a broader sense of CCP resilience than deploying a wide variety of market shocks each year.

The Bank therefore proposes to limit the number of market scenarios applied in individual supervisory stress tests. Though the precise approach will differ between supervisory stress tests, the Bank anticipates individual tests will typically apply between one and three core market shock scenarios before the application of sensitivity and reverse stress testing. The Bank also expects to apply the same scenario(s) for both the credit and liquidity components of its supervisory stress tests, and anticipates that all CCPs will face the same scenario shocks in individual supervisory stress-test exercises.

Standardisation versus flexibility

Running distinct market stress scenarios for each individual supervisory stress test will allow the Bank to explore a wide range of risks, focus individual supervisory stress tests on distinct risks and vulnerabilities, and adapt stress tests to market conditions.

On the other hand, running more standardised market scenarios across individual supervisory stress tests would better assist the Bank’s ability to identify changes in the resilience of individual CCPs and the clearing network over time. As such, a more stable market scenario could act as a useful benchmark with which to independently examine the adequacy of CCPs’ financial resources against the Cover-2 standard and monitor the evolution and changing pattern of risks overtime, helping to alert authorities when unexpected results are observed. Standardised scenarios would likely become less resource intensive than distinct scenarios over time, and therefore support shorter time lags between the start of supervisory stress tests and the delivery of results. However, developing a relatively stable scenario that remains relevant over time, and does not incentivise certain pre-emptive actions at CCPs, is likely to be more challenging. Some methodologies for scenario development, covered above, are likely to be more applicable to standardisation (or some form of consistent methodology) over time.

A CCP supervisory stress-testing framework that incorporates both standardised scenarios and more distinct scenarios would support Bank’s ability to assess certain risks and vulnerabilities that warrant more attention at a given point in time, the adequacy of CCPs’ financial resources against the Cover-2 standard, and how risks and the overall resilience of CCPs evolve over time. However, incorporating both elements in the Bank’s CCP supervisory stress-testing framework will involve greater resource costs, and so consideration is needed as to the additional benefits of doing so.

The Bank therefore welcomes views on the appropriate balance between running distinct versus continuous scenarios each year, and/or incorporating a form of standardised market scenario in its scenario set each year.

Risk factors

Determining which risk factors to specify in a market shock is an important aspect of developing market stress scenarios, and there are different approaches that can be taken for selecting risk factors.

For example, the Bank could chose to select a stable set of risk factors that are included in each supervisory stress-test scenario, or take a more dynamic approach where risk factors chosen will depend on the nature of the stress test undertaken or the major exposures of the CCPs in scope. Likewise, the Bank could choose to adopt a particular methodology for selecting risk factors, or do so on a judgement-led basis.

Overall, the Bank proposes that the risk factors specified in its market stress shocks cover a range of risk factors that are more important for CCPs business and enable CCPs to appropriately extrapolate to non-specified risk factors. By limiting risk factor specification to the most important risk factors, the Bank intends to reduce the resource costs involved in generating market stress scenarios, and minimise the risk that its risk factor shocks are individually or collectively implausible. The Bank intends to further develop its methodology for the selection of the most important risk factors over time, though will use a predominantly judgment-based approach in the short term.

Risk factor shocks will also account for the time horizon of CCP risks, and therefore the Bank intends to publish the daily paths of the risk factor shocks it specifies over the stress test horizon. The Bank does not intend to examine the impact of credit or liquidity stresses on an intraday basis in the short term.

Discussion questions:

7. Are there specific scenarios or types of scenarios that would be material for CCPs in scope which participants believe should be prioritised by the Bank?

8. Should the Bank’s market shock scenarios be broadly as severe as historical shocks or CCPs’ own stress-test scenarios, or test CCPs against a higher level of resilience? How important is it for market shocks to stress CCP services to a similar degree of severity?

9. Should the Bank apply a standardised market scenario as part of each supervisory stress test, to aid comparability of results over time? If so, are there particular design or methodologies with which such a scenario should be developed?

4.5: Reference dates

While CCPs undertake their own stress tests at least daily, the more infrequent nature of supervisory stress tests requires that they are run on a specifically chosen reference date or reference dates. Reference dates determine the starting point for CCPs in supervisory stress testing, so can have a significant bearing on the results of supervisory stress-testing exercises.

In particular, clearing members’ positions and CCPs’ resources fluctuate over the course of the year. This means that both the number of reference dates chosen and the nature of the chosen reference date(s) will affect the conclusions taken from a CCP supervisory stress test.

There are alternative approaches the Bank could take to reference date(s) selection, all of which would have a bearing on the Bank’s ability to assess individual and system-wide CCP resilience.

Using multiple reference dates – either for a single or multiple market scenarios – could help guard against the risk that a single reference date might lead to conclusions that were highly dependent on the selection of that particular reference date. On the other hand, a large number of reference dates would create additional resource costs for CCPs and the Bank. Further, as the number of reference dates used increases, so to would the difficultly of presenting a clear and coherent narrative on the findings of the supervisory stress test. This could confuse the messaging of supervisory stress-test results, to the potential detriment of public understanding of the supervisory stress-test results.

The nature of the chosen reference dates(s) is also an important consideration. For example, the Bank could focus on avoiding reference dates with irregular positions or market moves, or use particular reference dates to examine the impact of defaults during unusual but regularly occurring events. Likewise, the selected reference date(s) could be pre-selected from the past to avoid incentivising in-scope CCPs to adjust resources in advance of supervisory stress tests, or chosen from some point in the future (but prior to the start of the stress test) to minimise the time lag between the reference date and the publication of results.

If the Bank chose to use reference dates that were more representative of the positions CCPs have over time, there may also be a trade-off in terms of how recent those dates are. In particular, using more representative dates might provide a better general assessment of CCP resilience, while using a more recent (but less representative) date might enable the Bank to better assess the evolution of risks between regularly undertaken stress tests.

Overall the Bank proposes to maintain a degree of flexibility in the number and characteristics of the reference dates it applies in individual stress tests. Without being limited to doing so, the Bank will generally select reference dates that are representative of risks run over the previous year to avoid generating results that are overly determined by the choice of reference dates, and then seek to understand periods that could be considered as low points of resilience in the system. The Bank also does not intend to run a large number of reference dates in each stress test, in order to avoid any disproportionate resource costs that this might entail for CCPs and the Bank.

Discussion question:

10. What characteristics of reference dates (recentness, days of week, significant market settlement dates, etc.) are most important to support analysis of individual and system wide resilience? Are there benefits to assessing multiple reference dates for each market scenario?

4.6: Defaulter assumptions

The flexibility provided by CCP supervisory stress tests enables the Bank to examine a range of additional defaulter profiles and assumptions, in addition to the default of the Cover-2 population which is the focus of CCPs’ own stress tests.

Undertaking analysis of alternative – and potentially more plausible and severe – defaulter combinations through supervisory stress testing can help reveal the extent to which different populations of defaulters might have positions that generate outsized mutualised losses in certain stress scenarios. This would enhance the Bank’s ability to assess the resilience of individual CCPs, and explore system-wide resilience and interactions between CCPs and the rest of the financial system.

Extensions of Cover-2

Simple defaulter assumptions which the Bank could analyse in addition to Cover-2 include extending the Cover-2 default assumption to three, four or more clearing members with the largest stressed losses over initial margin at a CCP or CCP service. Supervisory stress tests could also be used to examine the impact of the default of clearing members with the largest stressed losses outside of those included in the Cover-2 population, or the default of a larger number of small clearing members. The Bank could also examine or identify clearing members whose losses are largest in proportion to (rather than above, in absolute terms) their own initial margin or default fund contributions. Each of these options would help the Bank assess default fund adequacy against multiple member default scenarios and be informative on the prudence of the Cover-2 standard against the default of non-Cover-2 populations.

System-wide approaches

Supervisory stress tests also enable the Bank to take a more systemic view. In particular, supervisory stress tests could be used to examine the impact of the default of common clearing members across in-scope CCPs, or the impact of the default of the two (or more) CCPs whose stressed losses over margin would be greatest in aggregate across all CCPs in scope of supervisory stress tests. This could help the Bank understand how severe the losses across CCPs would be in the event of common defaulters, identify which common defaulters would drive the largest losses across in-scope CCPs, and how non-defaulting members may face calls for default fund replenishment.

Characteristic-based approaches

Other options available to the Bank include using supervisory stress testing to examine losses caused by the default of members that share similar characteristics. For example, supervisory stress tests could examine the impact of the default of clearing members of a certain type, such as non-banks or equity broker dealers, or clearing members that share the same legal domicile. Similarly, the Bank could examine the default of clearing members that have high levels of correlation in their positions, or clearing members who are active in similar asset classes. This type of analysis could be particularly useful for identifying concentrated positions and concentration costs, and would be likely include defaulting populations not covered by Cover-2.

Supervisory stress tests could also be used to assess the impact of the simultaneous default of clearing members with similar or low credit ratings. These clearing members are those that are most likely to default, and are potentially more likely to default than firms in the Cover-2 population.

Statistical-based approaches

Finally, supervisory stress tests could also apply statistical approaches to identifying the population of defaulters. For example, the Bank could use the market shock provided or other analytical models to gauge clearing members most likely to default or fail to perform in the stress scenario. The Bank could also analyse probability weighted defaults, for example by weighting clearing member losses by the default probability of those members, and examining whether CCP resources are sufficient to cover this default weighted measure. Such approaches are likely to provide a complementary assessment of the prudence of the Cover-2 standard against default scenarios that are equally or more likely than the default of the Cover-2 population, and provide more comprehensive coverage of the clearing member population of CCPs.

Discussion question:

11. What are respondents’ views on the most insightful defaulter assumptions to examine through supervisory stress testing?

4.7: Sensitivity and reverse stress testing

The Bank intends to undertake both sensitivity analysis and reverse stress testing as part of its supervisory stress tests.

Sensitivity analysis

Sensitivity analysis – or sensitivity testing – will be used to explore the impact of changes in individual assumptions on individual and system-wide CCP resilience. For example, the Bank could use sensitivity testing to explore the impact of an alternative set of clearing members defaulting (eg how is CCP resilience affected if one additional clearing member defaults?). Likewise sensitivity testing could be used to examine impacts if market shocks increased or decreased in severity (eg how much greater would CCPs’ stresses losses be with a given population if defaulters, if market shocks were 10% more severe?). Sensitivity testing could also be used to examine the impact of adjusting other assumptions (eg to adjust assumptions around CCPs’ ability to port clients in a market stress).

Undertaking sensitivity testing will therefore provide the Bank with a more granular picture of individual and system-wide CCP resilience. It can also be used to identify which assumptions drive the results of supervisory stress testing. Where there is uncertainty in those assumptions, sensitivity testing will also provide the Bank with a view of how meaningful that uncertainty is for the results of individual supervisory stress tests.

Where possible, the Bank will undertake the analysis required for sensitivity testing. However, in some cases CCPs may be required to run analysis to feed into sensitivity tests, in particular where the assumptions being sensitivity tested are relevant for the calculation of profit and loss on clearing member accounts.

Reverse stress testing

Reverse stress testing will be used to identify the impact of increasing the severity of assumptions on CCP resilience, and for identifying combinations of assumptions that are likely to deplete CCP resources beyond normally accepted levels.

The Bank intends to undertake reverse stress testing across three dimensions: market shock severity, number and profile of defaulters, and concentration costs. For example, the Bank may look to examine the impact on CCP resilience of simultaneously scaling up the severity of market shocks and the number of defaulting clearing members, simultaneously scaling up the severity of market shocks and concentration costs, or simultaneously scaling up all three assumptions together.

Like sensitivity testing, reverse stress testing will help the Bank build a more granular understanding of CCP resilience, including by helping to identify how severe shocks and scenarios would need to be to deplete certain levels of resources at CCPs (even if that meant said shocks and scenarios were implausible). Reverse stress testing therefore also provides an important mechanism for promoting public confidence in the CCP system, by demonstrating the severity of shocks to which the Bank has found CCPs to be resilient. Further, to the extent that scenarios are comparable, reverse stress testing could provide a mechanism to assess CCP resilience over time. For example, reverse stress testing could help demonstrate whether the assumption combinations required to deplete a given level of CCP resources increased or decreased between supervisory stress-test iterations.

Different approaches could be taken for scaling up each of the three dimensions of the Bank’s reverse stress tests. For example, simple approaches to scaling up market shock severity could include applying linear multipliers to individual risk factor shocks and requiring CCPs to re-run profit and loss calculations. More sophisticated approached might involve scaling up risk factor shocks individually or collectively according to historical distributions, or by some function of their margin period of risk. The Bank proposes to maintain flexibility around the precise approach to undertaking reverse stress testing, and intends to enhance its methodology for undertaking reverse stress testing over time.

Discussion question:

12. Which assumptions and elements of the Bank’s supervisory stress tests should be prioritised for sensitivity analysis and/or reverse stress testing, and would provide the most valuable insights to respondents?

4.8: Disclosure

Disclosure has a number of benefits that can help the Bank meet its objective of promoting transparency and establishing public confidence in the UK clearing system. Publishing the methodology and results of supervisory stress tests can facilitate greater understanding of CCPs, and help demonstrate the range of severe stresses against which the Bank expects CCPs to be resilient. Disclosure can be used to provide information to market participants on the performance of CCPs, and provide a mechanism through which the Bank can be held accountable to Parliament and the wider public on its financial stability objective.

More broadly, disclosure can help incentivise the full engagement of participants in supervisory stress tests, therefore benefitting the Bank’s assessment of CCP and system-wide resilience. Disclosing analysis and results can also help support the credibility of any policy interventions or supervisory responses undertaken by the Bank in response to stress test findings.

Reflecting the benefits of disclosure, the Bank proposed to take the following high-level approach to the disclosure of its supervisory stress-testing approach, results and outcomes:

  • Approach – explanations and information on how the Bank of England will conduct its supervisory stress tests. The Bank expects to disclose a sufficient amount of information on the methodology of each supervisory stress test in order to ensure key stakeholders can engage with the broad analytical approach of each exercise. For example, the Bank is likely to disclose information on scenarios, analytical methodology, models used and critical assumptions. The Bank also intends to make public its framework for CCP supervisory stress testing, in order to enhance the transparency of that framework.
  • Results – analytical results of the stress-testing exercises. Disclosure of the results of the exercise, either aggregated or institution-specific, are necessary in order to justify and support the credibility of policy actions taken on the back of supervisory stress tests. The Bank intends to publish results against a set of clear, understandable and rigorous metrics, and at a sufficiently granular level to ensure results can be easily interpreted and support effective decision making, whilst balancing against the need to protect sensitive data and avoid market impacts.
  • Outcomes – explanation and disclosure of policy informed by supervisory stress test findings. At a minimum, the Bank expects to disclose the policy actions informed by the stress-testing exercise.

Metrics for results disclosure

Given the range of potential metrics against which the Bank could assess CCPs and publish results, the Bank welcomes respondents’ views on appropriate metrics with which to assess and disclose the results of CCP supervisory stress tests. For example, the Bank could examine individual and system-wide resilience, and publish results of supervisory stress tests, using a combination of the metrics below:

  • Drawdown of resources – the extent to which stressed losses or liquidity outflows lead to a drawdown of CCPs’ available financial and liquidity resources. For example, the size of stressed losses, what share of initial margin, default fund, powers of assessment, liquidity resources in cash/non-cash and different currencies are drawn down.
  • Source of losses and outflows – the amount of stressed losses or liquidity outflows arising at different nodes of the exercise (such as type of account, or CCP) and the source of those losses (for example, whether results are driven by particular risk factors or defaults).
  • Diversification of stress losses and liquidity outflows – the diversification of resources available to CCPs, such as the concentration of collateral per issuer, reliance on particular liquidity providers or funding sources, or the interconnectedness of clearing participants and CCPs.
  • Scenario comparison – comparing the amount of stressed losses and liquidity outflows arising under different stress scenarios.
  • Qualitative measures – reliability of CCP contingency measures, whether multiple CCPs rely on the same contingency measures, and/or the extent to which CCPs exercise discretion in their risk management approach.

It is important that the risk metrics adopted are clear, understandable and rigorous, as poorly constructed and designed metrics risk providing authorities, market participants and the wider public with misleading or unclear information and potential issues regarding the commercial sensitivity of information on the performance of CCPs and could result in supervisory stress tests failing to meet the Bank’s objectives.

Granularity of disclosure

The Bank also welcomes the views of those responding to this Discussion Paper on the most appropriate levels of granularity and anonymisation of supervisory stress-test results to achieve its objectives for CCP supervisory stress testing.

While the presentation of results at the greatest level of granularity would support the Bank’s objective of promoting transparency in the UK CCP system, CCP supervisory stress tests inherently involve firm-specific, non-public information, for which inappropriate disclosure has the potential to undermine the Bank’s other supervisory stress-testing objectives. In particular, the Bank is keen that the disclosure of results does not create moral hazard or generate negative self-fulfilling expectations, and that the benefits of disclosure are also weighed up against potential issues regarding the commercial sensitivity of information, and the resource costs involved with publishing information at more granular levels of detail.

Discussion questions:

13. What do respondents’ consider to be the most appropriate quantitative metrics for assessing CCP resilience, and for disclosing supervisory stress testing results?

14. What are respondents’ views on the appropriate balance between granularity and anonymisation of CCP supervisory stress testing results?

15. What level of granularity in the quantitative stress-tests results would be most valuable? Should disclosure focus on results presentation or an analysis of drivers, and assessment, of risk?

Box B: Emerging plans for the Bank’s 2021–22 CCP supervisory stress test

The Bank of England will undertake its first public CCP supervisory stress test over 2021–22. This stress test will be used to explore system-wide credit and liquidity resilience of CCPs, including the consequences of CCPs’ actions for other parts of the financial system such as non-defaulting clearing members.

As such, the 2021–22 stress test will include both a credit stress test component, and a liquidity stress test component. The credit component will test the sufficiency of CCPs resources to withstand clearing member defaults under market stress. The liquidity stress test will test CCPs’ ability to service all relevant cash requirements under market stress, under the default and non-performance of clearing members and service providers. Both elements will include an examination of concentration costs – that is the additional costs that occur when CCPs liquidate large directional exposures of defaulting entities in a short period of time.

The Bank will apply a baseline market stress to both the credit and liquidity components of the 2021–22 SST. This market stress will be hypothetical, but broadly based on – and equivalent to – CCPs’ own severe historical scenarios. The Bank will also undertake sensitivity testing and reverse stress testing. Sensitivity testing will be used to explore the impact of deviations away from baseline assumptions, including but not limited to those regarding the severity of market shock, and the number and profile of defaulting clearing members. Reverse stress testing will be used to examine the impact of increasingly severe assumptions on CCPs resilience, in an attempt to identify combinations of assumptions that are sufficiently severe to push CCP resource depletion beyond normally acceptable levels.

The three recognised UK CCPs: ICE Clear Europe Limited (ICEU), LCH Limited (LCH), and LME Clear Limited (LMEC) will participate in the test. All of the clearing services of each of these CCPs will be in scope of the exercise.

The Bank of England intends that the findings from running this exercise also help support the development of the Bank’s medium-term framework for CCP supervisory stress testing. As such, the 2021–22 CCP SST will be exploratory in nature, and the Bank is not seeking feedback on the design of the test. The test will not be testing CCPs against regulatory requirements, or using pass-fail thresholds. However, if deficiencies are identified the Bank will take the appropriate remedial action.

The Bank will launch this exercise with in-scope CCPs around the start of Q4 2021, and the Bank intends to publish the outcomes around the end of 2022 Q2. The Bank therefore anticipates the exercise to be run over a nine-month period.

Box C: Differences between CCP and Bank stress testing

Supervisory stress-testing regimes for the banking system are now well-established practice for regulators both domestically and internationally. In the UK, for example, the Bank of England undertook its first public stress test of the UK banking system in 2014, and published its overarching approach to stress testing the UK banking system in 2015. Since 2014, the Bank of England has undertaken banking sector stress tests on an annual basis, and has also been undertaking more exploratory analysis through its Biennial Exploratory Scenarios (for example, the 2021 BES on the financial risks from climate change).

CCPs have a number of differences from banks that need to be reflected in the approach to CCP supervisory stress testing. These differences include, but are not limited to, the following:

  • CCPs as risk managers – CCPs’ direct market risk exposures generally crystallise following the default of a clearing member or investment counterparty. As such, CCP stress-test scenarios typically need to include a combination of market price shocks and clearing member/liquidity provider default scenarios in order to be relevant for CCPs.
  • Scenarios and risk drivers – CCPs are exposed to sudden fast-burn shocks that typically take place over a horizon of less than ten days. Unlike for banks, slow-burn, long-horizon macroeconomic scenarios are therefore less likely to be relevant for CCPs. In the event that CCPs become exposed to market risk shocks due to the default of one of more clearing members, CCPs are also expected to close the relevant positions within a short-time frame to return to a ‘matched book’ or net-zero portfolio.
  • Interdependence with the financial system – CCP risk exposures generally derive directly from their clearing members’ own trading activities. These activities may not be stable over time, and mutualised structures such as default funds create a further layer or interdependence between CCPs and their clearing members.

While the development of banking sector stress tests provides a useful precedent for CCP supervisory stress tests, CCP supervisory stress tests must therefore be suitably adapted from existing approaches for stress testing the banking sector.

5: Providing feedback and next steps

5.1: How to provide feedback

The Bank would welcome feedback from interested parties on the different elements of the Bank of England’s CCP Supervisory stress-testing framework and the options outlined and proposed in this paper. Feedback on the questions listed in Section 5.2 would be particularly welcome and valuable in informing the development of the Bank’s framework for CCP supervisory stress testing.

Feedback should be sent by 17 December 2021 to CCP-SST@bankofengland.co.uk

5.2: Discussion questions

Risk coverage

1. Within the specified risk coverage, what specific risk exposures or areas should be prioritised for more granular analysis and disclosure?

2. Are there other risk exposures that supervisory stress testing would be the most optimal tool to assess from a regulatory perspective?

3. Should the Bank develop an approach for assessing default-related operational risks? If so, what methods could be deployed for assessing these risks?

Timing and frequency

4. What are respondents’ views on the proposed launch and publication dates of the Bank’s CCP supervisory stress tests? Are there benefits to launching stress tests and publishing results at alternative dates?

Methodology

5. Are there areas or assumptions within the methodology as described in this Discussion Paper that respondents consider particularly important or insightful, and should be prioritised in the analysis and disclosure of results?

6. Are there specific vulnerabilities, dependencies or risk exposures of UK CCPs that respondents believe are not sufficiently covered by the methodology as described in this Discussion Paper?

Scenario design

7. Are there specific scenarios or types of scenarios that would be material for CCPs in scope which participants believe should be prioritised by the Bank?

8. Should the Bank’s market shock scenarios be broadly as severe as historical shocks or CCPs’ own stress-test scenarios, or test CCPs against a higher level of resilience? How important is it for market shocks to stress CCP services to a similar degree of severity?

9. Should the Bank apply a standardised market scenario as part of each supervisory stress test, to aid comparability of results over time? If so, are there particular design or methodologies with which such a scenario should be developed?

Reference dates

10. What characteristics of reference dates (recentness, days of week, significant market settlement dates, etc.) are most important to support analysis of individual and system-wide resilience? Are there benefits to assessing multiple reference dates for each market scenario?

Defaulter assumptions

11. What are respondents’ views on the most insightful defaulter assumptions to examine through supervisory stress testing?

Sensitivity and reverse stress testing

12. Which assumptions and elements of the Bank’s supervisory stress tests should be prioritised for sensitivity analysis and/or reverse stress testing, and would provide the most valuable insights to respondents?

Disclosure

13. What do respondents’ consider to be the most appropriate quantitative metrics for assessing CCP resilience, and for disclosing supervisory stress testing results?

14. What are respondents’ views on the appropriate balance between granularity and anonymisation of CCP supervisory stress testing results?

15. What level of granularity in the quantitative stress-tests results would be most valuable? Should disclosure focus on results presentation or an analysis of drivers, and assessment, of risk?

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