History of Central Counterparty Failures and Near-Failures
By John Kiff
Central counterparty (CCP) failures have been extremely rare—there have been only three going back to 1974. There are additional instances of close calls or near failures. This post reviews the circumstances behind the three failures as well as two near misses, and then draws some key lessons from these episodes.[1] The French Caisse de Liquidation clearing house was closed down in 1974 as a result of unmet margin calls by one large trading firm after a sharp drop in sugar prices on the futures exchange. One of the primary causes of the failure was that the clearing house did not increase margin requirements in response to greater market volatility.[2] Also, although it lacked the authority to order exposure reductions, the clearing house should have informed the exchange (which had the authority) of the large size of the exposure of Nataf Trading House. The problem was further aggravated when the clearing used questionable prices and nontransparent methods to allocated losses among clearing members.
The Malaysian Kuala Lumpur Commodity Clearing House was closed down in 1983 as a result of unmet margin calls after a crash in palm oil futures prices on the Kuala Lumpur Commodity Exchange. Six large brokers that had accumulated huge positions defaulted as a result of the large losses that were generated by the price collapse. Again, the clearing house did not increase margin requirements in response to greater market volatility. Furthermore, there was a coordination breakdown between the clearing house and the exchange, which did not exercise its emergency powers to suspend trading. Also, sloppy trade confirmation and registration resulted in long delays in ascertaining who owed what to whom.
The Hong Kong Futures Exchange had to close for four days, and be bailed out by the government in 1987, as a result of fears of unmet margin calls on purchased equity futures positions following the October stock market crash.[3] Adding to the situation was that many of the sold equity futures positions were being used to hedge purchases of stocks, so that a failure on the futures contract would likely require additional selling pressure by those holding the stocks themselves. Yet again, margin was not raised in amounts commensurate with rising volatility, plus many brokers were not diligently collecting margin from their customers.
Also, there was a lack of coordination between those monitoring the market and those providing the guarantees due to the separation of ownership of the exchange, the clearing house, and the contract guarantee fund. In addition, there were no position limits and market risk became concentrated in a few brokers and customers (five of 102 brokers accounted for 80 percent of open sold contracts).
Near Failures
Also in the wake of the October 1987 crash, both the Chicago Mercantile Exchange (CME) and the Options Clearing Corporation (OCC) encountered severe difficulties in receiving margin. In the case of the CME, failure was averted when its bank, Continental Illinois, advanced the clearing house $400 million just minutes prior to the opening bell in order to complete all the $2.5 billion in necessary variation margin payments. These included a $1 billion payment from a major broker-dealer that had remained outstanding despite assurances from its executive management of its ultimate arrival. Although the crisis was averted, the CME realized that clearing members retained too much discretion over the timely payment of margin and thus adopted a policy of automated payments from clearing members.
At the same time, similar problems occurred in clearing equity options trades on the Chicago Board Options Exchange. A large CM at the OCC had difficulties meeting its margin calls and required an emergency loan from its bank in order to avoid non-compliance. The OCC was also plagued by some operational problems, including the lack of an automatic payment system, and the OCC was late in making payments to its clearing members.[4] Also, the OCC and CME did not have joint or linked clearing arrangements, so traders who hedged options with futures on the CME experienced delays in transferring gains realized at one clearing house to cover losses at another.[5] Lessons
There are several overall lessons to be gleaned from these derivative CCP failures and near-failures. First, margin requirements should be adjusted frequently and collected promptly in order to secure contract performance. Automated payments systems can help avoid liquidity shortfalls at clearing members and the clearing house. Joint clearing or direct payment arrangements between clearing houses can relieve some problems with payment shortfalls.
Second, clearing and market oversight functions within a clearing house/exchange context should be well coordinated, so that position exposures can be monitored and appropriate steps quickly taken.
Third, market surveillance and the authority to manage potentially destabilizing exposures are critical. CCPs need to monitor positions, potentially impose limits on positions and daily price changes, and enforce exposure reductions if necessary. Even intraday exposures can pose problems, so capital or margin requirements based on volatility may be needed.
Operational risks can lead to failure during times of stress. Trades need to be confirmed and cleared promptly so as to minimize uncertainty as to exposures. Trade reporting is needed for proper market surveillance.
Footnotes:
* This is taken verbatim from Randall Dodd’s Box 3.5 in the International Monetary Fund’s April 2010 Global Financial Stability Report. The views expressed herein are those of the author and should not be attributed to the International Monetary Fund, its Executive Board, or its management.
[1] See Gregory, Jon, 2014, Central Counterparties: Mandatory Clearing and Margin Requirements for OTC Derivatives, Wiley Finance, for stories about some similar failures of non-derivative CCPs and exchanges. These included the near failures of the U.S. Commodity Exchange Inc. (COMEX) in 1980 and Brazil’s BM&F Bovespa clearing house in 1999.
[2] Hills, Bob, David Rule, Sarah Parkinson, and Chris Young, 1999, “Central Counterparty Clearing Houses and Financial Stability,” Financial Stability Review (June), Bank of England.
[3] See Cornford, Andrew, 1995, “Risks and Derivatives Markets: Selected Issues,” UNCTAD Review (Geneva: United Nations Conference on Trade and Development), pp. 189–212, and Hay Davison, Ian, 1988, The Operation and Regulation of the Hong Kong Securities Industry: Report of the Securities Review Committee, (Government of Hong Kong, May 27).
[4] Cornford, Andrew, 1995, “Risks and Derivatives Markets: Selected Issues,” UNCTAD Review (Geneva: United Nations Conference on Trade and Development), pp. 189–212, and General Accounting Office (GAO), 1990, Clearance and Settlements Reform: The Stock, Options and Futures Markets Are Still at Risk (Washington: U.S. Government Printing Office).
[5] In addition, a major broker’s automated order submission systems did not accommodate options prices above $99.99, and so account payment instructions were sometimes understated (e.g., a price of $106 appeared as $6). Plus, in hindsight, there was a risk management failure in that it appears that too many market makers were selling insufficiently hedged puts with too little margin.