Updated: Feb 11, 2019
Central counterparties may elect not to run a default fund, particularly in emerging markets where resources are more scarce, but they must construct a robust default waterfall and deploy technology to support default management, writes Tore Klevenberg
Clearing house risk management has been thrust back into the spotlight in recent months, raising important questions over how to maintain robust standards in emerging markets where market participants have less resources to contribute to a default fund. A clearing member default at Nasdaq Clearing in September 2018 highlighted the need for improvements in margining and risk management practices among central counterparties (CCPs), prompting industry bodies to update their guidance in this important area.
The default fund, comprised of clearing member contributions, is typically the central component of the ‘default waterfall’ that provides the playbook for managing a default scenario, but it is important to recognise that it is not indispensable. Viable alternatives to the default fund are available, particularly in emerging markets where participants may not be able to post sufficient collateral to keep it topped up.
Examining the status quo
In accordance with industry best practice, the default waterfall is designed to prioritise the resources that would be drawn down to manage a clearing member default. Most waterfalls begin with the defaulter’s margin, which should usually be sufficient to cover the loss. If not, the waterfall would typically move on to the defaulter’s own contribution to the default fund, followed by a tranche of the CCP’s capital, before moving to the default fund contributions of the non-defaulting clearing members.
However the waterfall is structured, there is a clear distinction between the defaulter’s own resources – including its initial margin and contribution to the default fund – and the resources of the CCP and its members. The waterfall structure should ensure that the impact of a member default is kept to a minimum, ideally confined to the defaulting member’s own resources. The further down the waterfall a CCP is forced to descend, the greater the impact of the default will be.
The default fund is central to this waterfall model, but as we have written previously, there is an alternative in the ‘CCP-light’ model. And there is a menu of options available to safely manage the default of a clearing member without ever having recourse to a default fund.
Default management tools
The menu of tools is a diverse one. Variation margin gains haircutting, often the final resort in a conventional default waterfall, allows the CCP to impose a haircut on the variation margin gains on the portfolio of trades of each beneficial owner accumulated since the start of the default management process. Alternatively, a haircut can be taken from members’ initial margin contributions to cover the losses.
Other default management options include forced allocation of the positions of the defaulting member, usually on a randomised basis, or partial tear-up of positions. Cash compensation would draw on the cash already posted by the defaulting member as margin, while another option would be to hold an auction of the defaulting member’s portfolio on the open market, either for the whole portfolio in one chunk or on a piece-by-piece basis. Finally, CCPs can take out insurance to cover a certain level of losses, funded by raising a premium from members. Buy-in can be used where the CCP goes into the market to buy assets that the defaulting party has failed to deliver.
These diverse tools can be used by CCPs without a default fund to create their own unique waterfall structure. Detailed consideration must be given to which tools would be most appropriate and in what order they should be drawn down, but it is important to recognise that risk can still be managed very conservatively without having to rely on a default fund.
Reducing default likelihood
All of these tools are about planning for the worst-case scenario, of course. But the ideal outcome for any CCP, whether it operates a default fund or not, is to avoid defaults altogether.
One of the most important components of a CCP’s operations is the way in which market risk is measured and margin is calculated. Historically there has been a choice between value-at-risk (VAR) and the standard portfolio analysis of risk (SPAN). The differences between the two models have been widely debated, but the market is generally now moving towards VAR rather than SPAN.
The CCP must ensure it uses the correct margin period of risk (MPOR) to reflect the actual volatility in the market and the risk of the product being cleared. As the International Swaps and Derivatives Association noted recently in its recommended best practices for CCPs, a dynamic and transparent approach should be used to determine the right MPOR that properly accounts for the risk of the cleared product.
In addition to the underlying risk model, CCPs must also use certain add-ons to manage risk and reduce the likelihood of default. For example, an expected shortfall add-on can be used to factor in the risk of extreme scenarios, while a wrong-way risk or a concentration risk add-on can be used to manage specific high-risk scenarios that may arise. Wrong-way risk might occur if a bank either owns stocks in its own company or is heavily invested in its own sector, so if the sector suffers, it is at added risk, while concentration risk arises when the portfolio is very heavily concentrated in certain sectors.
Fundamentally, it is incumbent on CCPs to set and maintain rigorous membership standards to keep the probability of default to a minimum. Firms should be thoroughly assessed when they apply for membership to make sure they comply with minimum standards, and their finances and positions should be regularly monitored as time goes on.
CCPs without default funds must also be very careful about the kind of assets that are accepted as collateral, with cash and highly liquid assets being the gold standard. If clearing members are allowed to post other instrument types that may not be as liquid as cash, it becomes harder to deal with losses in a stress scenario.
Once CCPs have determined what tools they will draw on for the default waterfall and taken appropriate steps to manage membership rigorously and keep defaults to a minimum, the final piece of the puzzle is technology. In a default scenario, CCPs need reliable systems to deliver information in real-time when it is needed.
Such systems must be capable of providing a thorough overview of the portfolio and obligations of a particular clearing member so that the default committee and risk department can make decisions quickly during a default. Technology is also needed during the auction process so that the impact of any portfolio adjustment can be seen immediately.
Effective use of technology should ultimately be an important step towards more automated default handling, which is currently fairly rare. Manual default handling is still a necessity in some markets, particularly in those with low volatility or where manual control may be needed. But in volatile markets with high transaction volumes, there is a case to be made for greater automation and the tools are available to make this work.