What stress scenarios are central counterparties most worried about? What tools should clearing houses use to re-establish a matched book in the event of a clearing member default? And what are the main outstanding issues to be addressed? IQ: ISDA Quarterly asked three leading CCP operators for their thoughts
IQ: What stress scenario keeps you awake at night and what have you done to mitigate the impact?
Sunil Cutinho, CME Clearing: The same thing has always kept us up at night: the chance that stress will affect markets or products where risk management discipline is not routinely applied. The bedrock of a strong risk management philosophy is to help prevent and mitigate a crisis through applying consistent practices such as margin and mark-to-market valuation to every single market participant as a matter of course. The absence of those practices—in any market—can create situations where participants can establish positions they cannot support if or when the market turns against them. Such a situation would start a domino effect that can cause systemic damage.
Michael Davie, LCH.Clearnet Group: This issue goes to the heart of a CCP’s responsibility: to keep functioning normally at all times and to safeguard the interests of the markets we clear.
It starts with strict membership criteria and how our independent risk committee decides which products we’ll clear, and on what terms. We benefit from members’, clients’ and venues’ input in establishing and challenging risk policies and practices. In a default, initial margin (IM) is our first line of defence. LCH.Clearnet calibrates IM to a 99.7% confidence interval across 10 years of data. Beyond IM, each service has a fully segregated mutualised default fund, each based on over 50 historical and potential extreme stress scenarios.
Paul Swann, ICE Clear Europe: Core to the operations of a central clearing counterparty is the management of risk, and ICE clearing houses undertake rigorous stress-testing scenarios as part of their regular risk controls. Stress testing is applied to ensure the robustness of ICE’s loss-absorbency arrangements and its liquidity arrangements.
ICE Clear Europe, for example, regularly tests its ability to withstand the default of its largest two clearing members under a wide range of stress scenarios. Such scenarios include a full range of historical scenarios experienced over the past 30 years, or as long as reliable data have been available, as well as a wide range of theoretical stress tests that reflect possible future scenarios, including changes in price correlations between related products. The full range of stress tests are subject to independent validation. Risk profiles and distributions are always vulnerable to change and models for risk need to be adapted. For this reason, stress scenarios and assumptions are kept under review by ICE Clear Europe’s risk department and by the relevant risk committee.
IQ: Briefly outline the pre-funded loss-absorbing resources you have at your disposal to address a default by one or more participants.
Sunil Cutinho, CME Clearing: If losses exceed the defaulter’s initial margin, concentration margin and guarantee fund contribution, CME Clearing bears the first loss from our $380 million contribution across all of our default waterfalls. Following our contribution, the mutualised pool of non-defaulting clearing firms absorbs the loss, and that pool is sized to cover the simultaneous default of two clearing members with the largest stress shortfalls at all times.
What I think we all need to consider is a question of incentives. CCPs bring no risk to the system that we exist to manage—instead, we manage the risk that other participants bring to the system and ensure they have sufficient skin in the game to cover the risk of their exposures and incentivise them to behave in the best interests of the system. Ultimately, our capital base will be at risk to cover the last loss or we will be exiting our sole business if we can’t cover it, which is an extremely strong incentive for us as a CCP to have prudent risk management.
Michael Davie, LCH.Clearnet Group: To minimise the impact on our surviving members in the event of a default, we follow the ‘defaulter pays’ principle. Our initial margin confidence interval is set considerably higher than the regulatory minimum. For the SwapClear service alone, this means we have some $9 billion more from the potential defaulters than would be the case if we ran to the US regulatory minimum.
“We’d support initiatives that encourage transparency so members and regulators can fairly compare risk and operations across different CCPs”
— Michael Davie, LCH. Clearnet Group
After initial margin, we maintain a fully funded CCP skin-in-the-game layer of capital ahead of mutualised default funds, which are fully segregated for each service. These resources are pre-funded, and the default fund is calibrated to cover the simultaneous default of our two largest members and their clients.
Paul Swann, ICE Clear Europe: First, default management arrangements are designed to cover losses arising from a clearing member default, and restore a balanced CCP position, without recourse to resources other than those of the defaulting clearing member. Second, loss-absorption resources are designed to protect against losses that exceed the resources of the defaulting participant. Such resources include the following layers: a) ICE Clear Europe’s own contribution to the default fund, which is used prior to non-defaulting members’ contributions to the mutualised default fund; b) non-defaulting members’ contributions to the mutualised default fund (which include additional pari-passu contributions from ICE Clear Europe); and c) powers to assess members for a limited number of additional contributions to default funds.
ICE Clear Europe contributes a total of $100 million in capital to the futures and options guarantee fund and approximately $28 million to the European credit default swaps guarantee fund, which could be drawn upon in the event of a default. Known as skin in the game, this is something that was first introduced at ICE Clear Europe when the clearing house was established in 2007.
IQ: The Committee on Payments and Market Infrastructures (CPMI) and International Organization of Securities Commissions (IOSCO) recommend a variety of tools to allocate uncovered losses and re-establish a matched book in the event of a participant default. Which do you favour?
Sunil Cutinho, CME Clearing: We strongly support CPMI-IOSCO’s assertion that the uniqueness of each default event must be taken into account when a CCP is determining the appropriate response. As such, a CCP’s measured, customised approach cannot be fully defined in advance without knowing the facts of the event at the time. That said, CME supports and has implemented CPMI-IOSCO’s proposal that members be incentivised to participate in the default auction, and help the CCP establish a matched book, by juniorising default fund contributions of ‘poor’ participants.
Michael Davie, LCH.Clearnet Group: If the pre-funded resources are exhausted in a default, our rules allow LCH.Clearnet to request additional contributions from surviving members to close out the defaulter’s positions. Some of our services can also use variation margin gains haircutting as a recovery tool. As a final step, we can seek voluntary member contributions to re-establish a matched book. If these efforts were to fail, the affected clearing service would close.
Importantly, our segregated default funds make it possible for the clearing service of one asset class to invoke a resolution procedure while other services continue.
Paul Swann, ICE Clear Europe: ICE is fully supportive of the CPMI-IOSCO standards relating to CCP recovery, and is currently implementing recovery plans comprising a range of tools, including powers of assessment, variation margin haircutting, powers to call a clearing moratorium, and ultimately a controlled process of contract tear-up. Such plans have been implemented at ICE Clear Europe for futures and options clearing and we are awaiting regulatory approval for credit default swaps clearing.
IQ: Several reports have argued that greater transparency over CCP risk policies and procedures is needed. Do you agree?
Sunil Cutinho, CME Clearing: Transparency has always been a focus at CME. Our public rule books, procedures and operating manuals, as well as our many client forums and working groups, have made us one of the most transparent clearing houses in the industry. We are the first CCP to provide clearing members with Payments Risk Committee reports and were among the first to publish our PFMI disclosures on our website. We welcome and encourage this transparency.
“The issues of cross-border regulation and equivalence continue to be a concern for all CCPs”
— Sunil Cutinho, CME Clearing
Michael Davie, LCH.Clearnet Group: More risk than ever is being cleared as a result of member demand and regulation. We’ve invested heavily in consultation and education to meet the needs of our members in a safe and responsible way. We are committed to providing comprehensive disclosure of our risk management policies and procedures. We’d support initiatives that encourage transparency so members and regulators can fairly compare risk and operations across different CCPs.
Paul Swann, ICE Clear Europe: ICE Clear Europe is supportive of transparency over CCP risk policies and procedures, while at the same time ensuring the protection of sensitive and confidential information of both the CCP and clearing participants.
ICE Clear Europe has an independent board of directors and separate product risk committees comprising up to 15 participants who operate on delegated powers from the board in order to ensure that the clearing house maintains and implements procedures, processes and controls to protect the integrity of the guarantee fund, as well as manage and mitigate credit and market risks. In addition, ICE Clear Europe has a Board Risk Committee, which comprises a non-executive chairman and equal numbers of clearing participants (CP) and non-CP users, who advise the board on key clearing participation and other risk issues.
IQ: What are the primary CCP-related issues still to be resolved by regulators, industry participants or CCPs?
Sunil Cutinho, CME Clearing: The issues of cross-border regulation and equivalence continue to be a concern for all CCPs, as ours is truly a global industry. Artificial regulatory arbitrage situations will only hurt industry participants, which will find themselves unable to secure comparable risk management and regulatory solutions across the globe, and therefore unable to support their global business. In addition, the issues of stress testing, resolution and recovery are areas where CCPs have a lot to bring to the table in developing standards. One-size-fits-all solutions will likely be ineffective for CCP risk management in the event of a default.
Michael Davie, LCH.Clearnet Group: We’d encourage greater transparency by disclosing margin methodologies to boost confidence in CCPs and enable regulators and clearing members to identify best practices. We would also welcome global coordination to harmonise standards on topics such as the requirements for CCP skin in the game.
Paul Swann, ICE Clear Europe: In Europe, some issues remain to be resolved such as determining the equivalence of third-country clearing regimes. We fundamentally support efforts to ensure continued stability and coherent regulation at a global level, and believe that equivalence and the harmonisation of rules are of paramount importance to ensure the implementation of robust financial reform and to avoid regulatory arbitrage across jurisdictions.
In addition, in relation to clearing mandates for the buy side, while these have been in place in the US for some time, there has been a delay in Europe. As a result, we are continuing to see ongoing disparity across the differing regulatory jurisdictions.
“There remain a number of different and conflicting views on the most appropriate structure and details relating to CCP loss-absorbency mechanisms, recovery plans and resolution arrangements”
— Paul Swann, ICE Clear Europe
Finally, despite broad international consensus relating to CCP recovery and resolution arrangements, there remain a number of different and conflicting views on the most appropriate structure and details relating to CCP loss-absorbency mechanisms, recovery plans and resolution arrangements. These differences have in certain cases prevented international agreement on CCP recovery and resolution arrangements. Given the cross-border coverage of a number of global CCPs and their users, international agreement and harmonisation is paramount.■