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Op-ed article by Erik Müller: “No use of tax money to bail out the financial system”

04 Apr 2017

Op-ed article by Erik Müller: “No use of tax money to bail out the financial system”

Eric Müller
In 2017, lawmakers and supervisory authorities continue their efforts to create a stable foundation for Europe’s financial markets. Over a period of almost ten years since the beginning of the crisis, they have achieved impressive results. Today, we use market structures that are much more robust and secure than they were back in the days when the majority of financial transactions occurred outside the regulated market infrastructure. Among other factors, this is due to lawmakers strengthening the role of central counterparties (CCPs) in the wake of the financial crisis. One of the key decisions of the G20 meeting in Pittsburgh in 2009 was to have standardised derivatives transactions settled by CCPs.

In Europe, the EU derivatives regulation EMIR ensures that this process runs smoothly. EMIR provides security mechanisms, turning CCPs into extremely robust and default-protected market infrastructures. For instance, Eurex Clearing operates a default fund to which its members make joint contributions. Eurex Clearing itself also contributes, and beyond that is liable with its own equity.

The idea: in a situation of crisis, our members, together with our company, cover the costs arising from the default of individual market participants. This is the right incentive for all market participants to manage risks in the interest of financial stability.

Brussels is currently working on two regulatory frameworks for CCPs. One represents a review of the existing EU derivatives regulation and the other is the European Commission’s draft of the CCP Recovery and Resolution Regulation, which represents the last missing part of the regulatory puzzle as far as central counterparties are concerned.

Until now, the financial system has been strengthened by the Bank Recovery and Resolution Directive (BRRD). The directive defines which creditor is liable in case of a default and at what point the respective credit institution has to be closed down. The draft of the CCP Recovery and Resolution Regulation covers, in particular, extreme yet plausible crisis scenarios in the unlikely event that the BRRD rules and EMIR security mechanisms are not sufficient to protect the financial system.

Consistent rules are crucial

The new regulation is an important step in the right direction, with lawmakers facing two challenges: new rules and amendments of EMIR must be consistent with other regulatory activities – and beyond that, they must be compatible on an international scale. Also, lessons learnt after the crisis are not to be ignored. We have all witnessed the damage which so-called moral hazard may do and acknowledge the importance of providing the right incentive structures. Therefore, not using taxpayers’ money should be the top priority. We need a financial system that does not rely on public funds to bail out troubled institutions.

This is where the legislative draft is still lacking, as it includes the possibility of a public bail-out. As long as this possibility exists, clearing members may be less inclined to rescue the CCP. Instead, market participants may prefer the option of the CCP defaulting, in which case the government would step in. This would create moral hazard at the very core of the financial markets, the CCP, which acts as a neutral and independent risk manager.

Joint crisis prevention

EMIR already requires central counterparties to be able, at any time, to absorb the simultaneous failure of its two largest clients. Furthermore, many CCPs – including Eurex Clearing – have developed a number of risk management tools and mechanisms that go far beyond regulatory requirements. All this serves to incentivise our clients to prepare for crises together with us. In the case of a default, we should jointly absorb losses in order to secure the stability of our financial system.

This is why the current compensation clause should be dropped from the CCP Recovery and Resolution Regulation draft. The clause is based on the idea that market participants are rewarded for jointly absorbing losses incurred by a failing clearing member. But why compensate the losses of a market participant when this member has already agreed – on a voluntary, contractual basis – to a loss allocation as part of today’s CCP rules and regulations? Some may argue the compensation clause creates an incentive for clearing members to participate in loss allocation in the first place. However, we believe another aspect to be far more important: if all members, together with the CCP, absorb losses in a situation of crisis, the continuous delivery of clearing services is ensured. And this continuous delivery is crucial, as it is the only factor that can guarantee adequate risk management provided via a neutral market infrastructure. As a result, our members continue to enjoy lower regulatory requirements regarding equity and will continue to be able to provide clearing services to their clients. This is the most important incentive of all.

With regard to other aspects, however, the new draft perfectly complements EMIR. It offers an excellent opportunity to improve CCP rules and regulations and strengthen risk management capacities. This can only succeed, however, if the right incentives continue to be offered. The financial sector has to be able to withstand extreme yet possible market scenarios – by its own means and without presenting a burden to taxpayers.

By Erik Müller, CEO of Eurex Clearing AG

The German version of this article originally appeared in the Börsen-Zeitung on 31 March 2017.

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