The first-ever resolution plan for a Canadian financial market infrastructure
The Payment Clearing and Settlement Act requires that the Bank of Canada develop a resolution plan for each domestic designated financial market infrastructure (FMI). In early 2024, the Bank completed its first resolution plan for a designated Canadian FMI. This plan applies to the Canadian Derivatives Clearing Service (CDCS), which is operated by the Canadian Derivatives Clearing Corporation (CDCC). Other designated FMIs within the scope of the Canadian resolution regime include CDSX, Lynx, the Automated Clearing Settlement System (ACSS), Interac e-Transfer® and the Interac Inter-Member Network.
To develop a credible resolution strategy, it is essential to have a sense of the magnitude of potential losses that the Bank will likely have to temporarily manage if an FMI were to fail. For this purpose, we apply the methodology based on the extreme value theory (EVT) for stress-testing central counterparties (CCPs) that was developed in Raykov (2022) to estimate the amount of default losses for various scenarios of CDCC’s failure.
In this note, we provide an overview of this methodology, which can help estimate financial resources that may be needed to successfully resolve CDCC.
Why financial market infrastructures need resolution plans
FMIs are systems for making payments and for clearing and settling financial transactions. Because they are crucial to the financial system, the services they provide must continue even in periods of extreme stress. Therefore, the Bank designates and oversees FMIs that pose systemic risk to the financial system. These FMIs must have robust risk management practices in place. As a result, it is unlikely that a designated FMI would fail. Nevertheless, the Bank, as resolution authority for Canadian FMIs, needs to be well prepared and have the tools to respond if necessary. For this reason, the Bank has a resolution regime for domestic designated FMIs with objectives aimed to:
- promote financial stability
- maintain the continuity of FMIs’ critical services
- minimize the exposure of public funds to loss
One element of the framework is resolution plans that describe on a strategic level how to respond to the unlikely failure of a designated domestic FMI. They are customized to the FMIs that they are prepared for and include sections on the risk profile of the system, resolution strategy, financial resources assessment and operational plan (Bank of Canada 2020). These plans must be updated at least once every 12-month period.
When an FMI is in resolution, the Bank might need to temporarily provide financial resources to stabilize the FMI and to minimize any disruption in the provision of its critical clearing and settlement functions. To this end, the Payment Clearing and Settlement Act gives the Bank the power to take temporary control of a failing FMI to limit the impact of its failure on Canada’s financial system and economy. The Bank will recover the cost of resolution from the FMI and its members afterward to mitigate any moral hazard and meet its statutory obligation to minimize loss of public funds. The financial resources section of the resolution plan helps the Bank determine the amount of funds that would be temporarily needed to support resolution.
Overview of CDCC’s credit risk and default management resources
CDCC is a systemically important CCP that provides a central clearing service for:
- exchange-traded derivative products (futures and options) traded on the Montréal Exchange
- over-the-counter Canadian fixed-income transactions (both cash and repurchase agreements) and equity options
Both the exchange-traded derivatives and fixed-income clearing services are critical to the stability of the Canadian financial system and would need to be supported by the Bank during resolution. Currently, the clearing services that CDCC provides to the Canadian financial market have no substitute.
CDCC serves more than 30 clearing members, including major financial institutions and brokers in Canada as well as their clients worldwide. This includes the six Canadian systemically important banks and their broker-dealer subsidiaries and the Canadian investment dealer subsidiaries of some large foreign banks.
As a CCP, CDCC reduces counterparty risk for its clearing members by becoming the counterparty in each contract through a process known as novation. Novation replaces the original contract between the buyer and seller with two new contracts: one between the CCP and the buyer and the other between the CCP and the seller. As a result, if a clearing member were to default, CDCC must meet that member’s obligations until its positions are closed out. Because losses can be incurred during the management of the default, CDCC is exposed to credit risk and must maintain pre-funded financial resources to absorb such losses.
The pre-funded financial resources that CDCC can use to cover credit losses if a clearing member were to default are as follows.
- Initial margin: Collateral collected from each clearing member so that, if the member defaults, potential losses in the value of that member’s positions can be covered with a high degree of confidence (e.g., 99% or higher). Figure 1 shows that only the defaulting member’s initial margin is used to cover losses when a default occurs.
- Clearing fund: A mutualized fund with cash collected from CDCC’s members to account for extreme-but-plausible market events. Figure 1 shows that, in the case of a default, the losses are first covered using the defaulting member’s contributions and then CDCC’s default risk capital. Once those are exhausted, the survivors’ clearing fund contributions are used.
Because CDCC is designated as systemically important in Canada, its clearing fund is resized regularly to meet the Cover 1 regulatory standard, by maintaining sufficient pre-funded resources to cover the default of a single clearing member (and its affiliates) representing the largest stressed aggregate credit exposure for CDCC. - CDCC default risk capital: CDCC’s own capital reserves (skin-in-the-game).
CDCC’s default management framework (Figure 1) shows the order in which CDCC must draw on these financial resources. If residual losses remain after applying all the resources in the default waterfall, CDCC may initiate the recovery process as part of its default management framework. During this process, CDCC can use various recovery tools (e.g., reduced amounts distribution, cash calls, voluntary contract tear-ups) for loss allocation. If the Bank judges that exhausting the default waterfall and recovery actions results in financial stability risk, it may consider entering CDCC into resolution even before CDCC uses all the tools in its default management framework.