Clearing Through Central Counterparties: Core Risk Management and Default Management Concepts
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Central counterparties (CCPs) clear trades by becoming the buyer to every seller and seller to every buyer, guaranteeing contract performance. CCPs use initial and variation margin, stress testing, and oversight of clearing members to manage risk. In the event of a default, the CCP uses the defaulter's margin and guaranty fund contribution first before using its own pre-funded financial resources, which are sized to cover the default of multiple members if needed. CCPs thus help mitigate credit risk while supporting market liquidity and access.
Clearing Through Central Counterparties: Core Risk Management and Default Management Concepts
- 1. Clearing Through Central Counterparties : Core Risk Management and Default Management Concepts U.S. Commodity Futures Trading Commission Christa Lachenmayr Kevin Piccoli Tracey Wingate
- 2. Agenda • Clearing Process: (novation, offset, clearing members, and settlement) • Risk Management: (margin, stress testing, supervision of members and customer protection) • Default Management: (default procedures, guaranty funds, and financial resources) 2
- 4. What is Clearing? Clearing is the process by which trades in futures contracts, options on futures contracts, and swap contracts are processed, guaranteed, and settled by a central counterparty, referred to as a central counterparty (CCP). CCPs have “clearing members” or “clearing participants” that clear transactions on behalf of themselves, their affiliates, or customers. Central Counterparty (CCP) Buyer Seller 4
- 5. Novation (Agency Model) • The CCP becomes “the buyer to every seller and the seller to every buyer” (“novation”). – At the point where the trade becomes novated, the CCP guarantees the future performance of the contract. – The CCP guarantees the performance of each clearing member’s trades and open positions to every other clearing member. • Thus, the clearing members’ exposure for open positions is to the CCP. Clearing members do not have direct exposure to other clearing members. 55
- 6. Central Clearing and Credit Risk • The ultimate function of a CCP is to assure performance of contract obligations. • Risk is not eliminated but mitigated – as the substituted counterparty to all trades accepted for clearing. • Clearing thus plays an important role in managing the risk in the markets as well as providing a mechanism for market entry and exit that supports liquidity. 66
- 7. Non-Cleared Markets Without clearing, each market participant must: Assess creditworthiness of potential counterparties. Set counterparty credit limits. Collect collateral. Monitor counterparties’ credit. Make multiple payments to/from each counterparty or agree to net. Pay to/collect from each counterparty. 7 7
- 8. Clearing Relationships • Market participants (i.e., customers) must have their trades carried (guaranteed) to the CCP by a clearing member. • Clearing members can carry their own trades, or those of their affiliates. 8
- 9. Structure of Clearing Relationships- Agency Model Clearing CCPs have a legal relationship only with entities that they have admitted as clearing members. CCPs have no legal relationship with the customers of their clearing members. CCP Member Customer Customer Member Customer Customer 9
- 10. Clearing Members 10 The CCP only admits clearing members that qualify with sufficient: The CCP qualifies each clearing member, so clearing members do not have to qualify each other as counterparties. Financial strength Risk Management sophistication Operational capabilities 10
- 11. Clearing Member Qualifications • A CCP has the ability to evaluate its members at several points: – Before initially admitting them. – During the periodic review of financial reports. – During periodic examinations. – In case of trouble. • Under the CFTC framework, CCPs are required to meet specific conditions of financial strength, and CCPs frequently set higher requirements. 11
- 12. Final Settlement To settle contracts that are expiring with a physical delivery rather than cash settlement, the CCP: – Assigns shorts (sellers) to longs (buyers). • Assignments bear no relationship to original counterparties. – Provides a venue for and assists with the verification of delivery. – Collects transactional costs and guarantees financial performance of delivery (but not the delivery of the physical commodity). For options on futures, the CCP: – Converts exercised options to futures. – May automatically exercise in-the-money options at expiration. 1212
- 14. Risk Management • CCP risk management framework should be consistent with the Principles for Financial Market Infrastructures (PFMI) • A comprehensive program that includes the management of credit risk, collateral, margin, liquidity risk, settlement finality, general business risk, custody and investment risks, operational risks, default rules and procedures, and viable recovery & wind-down plans. 1414
- 15. Core Elements • Initial margin • Risk management of clearing members • Stress testing 1515
- 16. Types of Margin Initial Margin (performance bond) Variation Margin (mark-to-market amount) 16
- 17. Setting Initial Margin • Initial margin should be “risk-based.” • The amount of initial margin is set for each contract using a statistical analysis based on the price volatility of the underlying product. • The calculation generally covers the largest one- day loss at a confidence level of 99%. • Under the CFTC Framework, CCPs must collect customer margin on a gross basis (but may collect margin for house accounts on a net basis). 1717
- 18. Evaluating Initial Margin Parameters • In circumstances of high volatility (e.g., oil price shocks, threat of failure of sovereign bonds), the CCP may impose an immediate increase in initial margin. • CCPs periodically will review initial margins as part of their overall risk management framework. 18
- 19. Acceptable Forms of Initial Margin Collateral • Initial margin should be posted to the CCP in the form of – Cash; or – Highly liquid securities • Securities accepted as initial margin are “haircut” – valued at a discount to their current market price – to account for the possibility they will be worth less when it may be necessary to liquidate them as a result of a failure of a clearing member to meet its obligations. • Under the CFTC Framework, CCPs must review haircuts at least quarterly. 1919
- 20. Setting Variation Margin (mark-to-market) • Each day, for each contract, a settlement price is determined. • For each position, a profit or loss is calculated (current price compared to the previous settlement price or intra-day mark-to-market price). • The CCP collects losses and pays gains at least once each day, and for some CCPs, twice per day. • This prevents the accumulation of losses. 2020
- 21. Pay / Collect = Gains / Losses • For each clearing member, profits and losses on all positions/cash flows are aggregated to a single net amount. • The CCP collects from those clearing members with aggregate losses, and pays to those clearing members with aggregate gains. – Collections and payments are made in immediately available funds. • After netting cash flows at each clearing member, the resultant pays and collects will net to zero at the CCP. 21
- 22. Settlement Banks • CCPs use the services of commercial banks to effect money settlements on behalf of clearing members; or where permitted or required, hold accounts at their jurisdiction’s Central Bank. 22
- 23. Financial Supervision of Clearing Members CCPs can manage risks associated with clearing members in various ways including setting exposure limits based on: – The characteristics of the clearing member (e.g., capital, parent guarantees) – Initial margin on deposit 2323
- 24. Financial Supervision of Clearing Members A CCP may take escalating action when exposure limits are neared or exceeded. • Contact the clearing member or settlement bank for reassurance. • Require early payments. • Issue unscheduled intra-day margin calls. • Increase margin required for positions that are large relative to their market (concentration margin). • Permit liquidation only. 2424
- 25. Stress Testing • Stress testing is aimed at determining whether the CCP has enough financial resources and/or liquidity resources to withstand market scenarios that are “extreme but plausible”. • Determining what constitutes extreme but plausible market conditions depends on a number of factors including, asset class, product volatility, historical market movements and current market conditions. • Critical risk management tool to ensure the resiliency of a CCP. 25
- 27. Default Management Plans • A default occurs when a clearing member fails to meet its financial obligation to the CCP. • CCPs should have default management procedures and plans that are tested and are made available to the public. • A CCP can take a variety of actions in the event of a default, including liquidating the defaulter’s positions in an orderly manner. • While the amount of initial margin on deposit with the CCP is calculated to equal or exceed the losses that might be incurred upon liquidation, a default is often associated with extraordinary circumstances and margin on deposit might not be enough. 2727
- 28. Default Management – Typically the Defaulter Pays First • Defaulter’s initial margin • Defaulter’s guaranty fund contribution – Defaulter’s contribution to the mutualized default resources is used before the contributions of the CCP or other clearing members. • Other property of the defaulter in the hands of the CCP 2828
- 29. Default Management – Other Resources • If the defaulter’s collateral is insufficient to cure the entire defaulted amount, the CCP will use the other components of its financial safeguards package, which may include a combination of: – Guaranty fund contributions from non-defaulting clearing members – A specified amount of capital set aside by the CCP in excess of operational funds – A standby credit facility (for liquidity) – The ability to assess each clearing member for specified additional contributions in excess of their basic default fund contributions 29
- 30. Pre-funded Financial Safeguard Package – How much? Cover 1 standard: CCPs should maintain sufficient financial resources to “enable the CCP to meet its financial obligations to its clearing members notwithstanding a default by the clearing member creating the largest financial exposure for the CCP in extreme but plausible market conditions.” (PFMI) – Includes both customer and proprietary positions. – Proprietary positions include positions of affiliates. – Resources must be sufficiently liquid. 30
- 31. Pre-funded Financial Safeguard Package – How much? Cover 2 standard: CCPs that are systemically important in more than one jurisdiction or that is involved in activities with a more complex-risk profile should maintain financial resources sufficient to “enable it to meet its financial obligations to its clearing members notwithstanding a default by the two clearing members creating the largest combined loss to the CCP in extreme but plausible market conditions.” (PFMI) – Includes both customer and proprietary positions. – Proprietary positions include positions of affiliates. – Resources must be sufficiently liquid. 3131
- 32. CONCLUSION 32
- 33. CONCLUSION • Clearing through CCPs can optimize market conditions through: – Market transparency, – Fair and orderly trading, – Efficiency. • However, it is the day-to-day risk management of a CCP, the knowledge that the CCP can pay its obligations everyday-in a timely manner-that instills confidence in market participants. This is the necessary ingredient to creating robust, active, deep derivative markets. 33