While traditional central counterparty risk models are designed to cover market risk under normal market conditions, there is now a clear need for best practice to handle additional risk controls and add-ons, including concentration and wrong-way risk, to ensure sufficient margin requirements are being met under stressed market conditions as well, writes Lily Lohne and Martin Grotle Soukup.
Following two separate incidents recently of clearing member defaults requiring their respective CCPs to use the mutualised resources in their default funds - the first in the futures segment of the Korea Exchange and the second at Nasdaq Clearing - the clearing community has now rightly turned its attention to preventing such a situation from occurring again.
As highlighted by the International Swaps and Derivatives Association in its recent paper on clearing risk management best practices, CCP risk management decisions should be based on the risk profile of a given derivatives product and not be reliant on a single risk factor as the determinant for exposure. Instead, it urges a more dynamic, holistic approach be taken, which recognises that risk management must be adapted in response to the evolving market conditions.
This has contributed to a wider industry discussion about the need for CCPs to employ additional risk controls and add-ons. ISDA makes a number of practical recommendations as to how this can be achieved, such as including concentration, liquidity and wrong-way risk in the margin calculations. These additional measures are now essential in ensuring that when large positions are built up in a portfolio or when extreme market conditions occur, then the margin calculation methodology is
able to take these tail risks into account and top up the collateral requirements accordingly.
Additional risk controls
In order for this to be achieved, it is essential that clearing systems operate margin models which are able to support multi-currency and multi-asset risk evaluations. At Baymarkets, we have recently implemented two specific risk add-ons to our Clara clearing platform in order to help reduce or mitigate the risk of a default situation. The concentration risk and wrong-way risk add-ons are an important step towards helping clearing houses address the uncertainty that exists in their current margin calculation methodologies and to ensure that the collateral requirements cover the
market risk of a given portfolio.
Under normal market conditions, for example, Clara calculates the value-at-risk (VaR) of a portfolio distribution using Monte Carlo simulation of the underlying risk factors, with a negative VaR posted as a margin requirement. Under stressed market conditions, however, concentrated positions built up in derivative portfolios will become more difficult to transfer or close out. In order to avoid this, the CCPs can calculate the exposure from all the positions held by a clearing member and evaluate the concentration risk that emerges from those positions. In our model, we categorize and calculate the exposure for each position. The total exposure is calculated for each underlying instrument and is then assessed in comparison to the average of historical traded volume registered in Clara. Using this relation together with the underlying scanning range, a fitting concentration add-on factor is determined by Clara. The add-on factor is then applied to the absolute value of each net position, which generates a clear concentration margin add-on. The margin add-ons for each net position that exceeds the CCPs position barrier are then summed together. If the resulting margin add-on exceeds the CCPs clearing member barrier it is then applied as a fixed add-on to the regular margin requirement.
In the case of wrong-way risk (WWR), there is an unfortunate correlation between market risk and the credit risk of the clearing member, which impacts the risk of default. This can take the form of specific WWR from long exposure in the member’s own issued securities, or general WWR from long exposure in either a sector, region or currency in which the counterparty is listed. Both are handled in the same fashion in the WWR add-on, which uses the correlation between market risk and credit risk as a tuning parameter. Under the ‘better safe than sorry’ conservative approach to creating CCP methodologies there are no benefits given for having a positive correlation, or right-way risk.
In developing our WWR add-on, we selected a gaussian copula model to describe the joint distribution of a member’s probability of defaulting and the market risk of an instrument. This also provides the added flexibility needed to cover both specific and general WWR risk. The probability of a member defaulting is derived using a rating of that member, while credit risk is taken from a Merton-based model. To find the additional wrong-way risk of a position, we define the WWR adjusted margin as the VaR of the conditional distribution market risk given that a default has happened in the close-out period. The WWR add-on for a position is given by:
WWR = VAR_WWR – VAR
…where VAR is the VaR of the market distribution without the conditional default event. The total portfolio WWR add-on is then just the sum of all these position WWR add-ons. The challenge with sampling a copula distribution of default events is that default probabilities tend to be very small. To overcome this, we deploy Markov Chain Monte Carlo methods to sample from the truncated distribution where the default event is being realised.
Safeguarding the markets
Under normal market conditions or in the case of manageable risk exposures from positions built up in a portfolio, there is of course no additional margin requirement needed from the clearing member. The concentration risk and wrong-way risk add-ons are intended to add a necessary layer of additional risk controls to the CCP’s margin calculation methodology. Participants that build up additional risk concentrations or large positions in their own sector are then required to post additional
collateral as a result.
In the case of more illiquid emerging markets, concentration risk can be particularly pronounced. The use by CCPs of a liquidity risk add-on should then also be an important consideration in the case of emerging markets where CCPs will often need to hold significant reserves as protection. In Clara we handle liquidity risk by adjusting the scanning range according to the underlying liquidity.
The increased interest from our client base is an encouraging indication that additional risk controls, including our concentration risk and wrong-way risk add-ons, are very high on the agenda for the clearing community. CCPs which take these additional measures to improve their risk management practices are helping to not only protect their members from additional losses as a result of a member default, but are proactively helping to safeguard the wider financial system from its impact as well.
ISDA Best practices: https://www.isda.org/a/cigME/CCP-Best-Practice.pdf