This is the fourth of my series of over-the-counter (OTC) derivative primers. The first three covered the instruments, risk management and clearing. This post covers central clearing and central counterparty risk management issues.
Central counterparty (CCP) risk management practices must conform to prudential standards set by national regulators that generally conform to CPMI-IOSCO international standards (PFMIs). These serve to protect clearing members (CMs) and their customers from CCP incentives to lower risk management criteria to stay competitive. These include minimum standards for CM initial margin (IM) and default fund (DF) contributions. Variation margin (VM) covers current exposures – day-to-day changes in net replacement costs – and IM and the DF cover potential future exposure (PFE). Other PFMI requirements pertain to operational capacity, relevant business expertise, and legal authority. If they are well managed and capitalized, CCPs can insulate clearing participants from each other’s default risk.
According to the PFMIs IM should cover current and potential future exposures to each clearing participant at a single-tailed confidence level of at least 99% of the estimated distribution of future exposure. DF is meant to cover stressed conditions. CCPs generally set the sum of the IM and DF to cover CM losses under a range of stress scenarios. These typically include the default of the one or two CMs that would potentially cause the largest aggregate credit exposures in extreme but plausible market conditions. The size of each CM’s contribution to the DF is in relation to the amount of risk each brings to the CCP. Hence, CMs must meet stringent financial resource and capital requirements, not only for managing their own positions, but to potentially pitch in if other CMs default.
If CMs fail CCPs coordinate the orderly replacement of trades with, and collateral from, failed CMs. This has to be done relatively quickly because a CM failure exposes the CCP to market risk because it no longer has a matched book. In order to return to a matched book, the CCP has to close out its unmatched positions by entering into offsetting/ hedging transactions and/or by auctioning the positions to non-defaulting CMs or other market participants and/or liquidating and re-establishing positions with surviving CMs upon closing of the old ones. For example, all of the centrally-cleared Lehman Brothers interest rate swap positions settled just a few days after the 2008 bankruptcy without tapping the DF (Financial News, 2008).
A CCP typically has in place a risk “waterfall” consisting of layers of protection to cover any losses resulting from these trade replacement operations. Below is an illustrative example of a CCP waterfall structure taken from a 2013 International Swaps and Derivatives Association (ISDA) report. These structures vary in each CCP and the PFMIs don’t prescribed one. Broadly speaking, CCPs subscribe to one of two waterfall models:
- Survivor-pay models minimize IM in order to incentivize constructive CM roles in post-default processes. ICE Clearing advocates this model on the basis of its small CM base and jump-to-default risk for its credit default swap clearing. CME Clearing also uses a survivor-pay model.
- Defaulter-pay models rely relatively more on IM to decrease moral hazard and make it easier to get surviving CMs to accept cleared positions of clients left in the lurch by another CM’s default. SwapClear advocates this waterfall model for its interest rate swap clearing operations.
The waterfall layers comprise prefunded financial resources consisting of margin, the DF and the CCP’s capital. Any losses are first covered by the defaulting CM’s margin contributions, and if that is not sufficient its default fund contributions are tapped. If even that is insufficient, the CCP steps in with its pre-defined contribution, a part of its own capital. This is followed by remaining default fund contributions. Also many CCPs have the ability to assess members for additional default fund contributions (typically up to a multiple of their initial contribution). When the CCP’s capital is exhausted, the CCP will cease operations, unless other loss sharing recovery mechanisms are in place such as margin haircutting.
End-of-waterfall recovery mechanism options/requirements are currently a matter of heated debate. For detailed discussions of the options see the 2014 Committee on Payments and Market Infrastructures - International Organization of Securities Commissions (CPMI-IOSCO) and ISDA papers on the topic. The most discussed options are:
- Variation margin haircutting (VMGH) that cuts VM payments to in-the-money participants but collects full VM from out-of-the-money participants. SwapClear and JSCC would apply VMGH at the end of the waterfall. (IM could also be tapped although as pointed out in a 2014 IMF working paper there are legal impediments under U.S. and EU laws.)
- Forced allocation in which unallocated defaulting CM positions are forced on to non-defaulting participants at a price determined by the CCP. ICE Clearing would impose forced clearing at the end of the waterfall.
- Termination of some contracts (partial tear-ups) in which only contracts needed to offset defaulted contracts, or to minimize netting set impact are terminated.
- Termination of all contracts (full tear-up) which is equivalent to CCP closure or wind-down. CME Clearing applies full tear-ups at the end of the waterfall.
For those wanting more in-depth coverage of CCP operations and risk management should check out Jon Gregory’s Central Counterparties and David Murphy’s OTC Derivatives books. The next post in this series will leave the world of OTC derivative risk management behind and move on to trade repositories.