Invoking the specter of the default of HanMag Securities Corporation on the Korea Exchange (KRX) last December (without referencing the firm by name), Commissioner Mark Wetjen of the Commodity Futures Trading Commission called last week for a dialogue regarding at least three proposals to enhance risk management by clearinghouses (CCPs). These proposals included (1) enhancing transparency by potentially instituting standardized stress tests; (2) requiring clearinghouses to maintain “skin in the game” as part of their default waterfalls; and (3) barring ultimate client collateral from non-defaulting members from ever being used as part of a clearinghouse’s default resolution.
Mr. Wetjen provided his insight during a speech before the FIA Asia Derivatives Conference held last week in Singapore.
Previously, on December 12, 2013, HanMag, a KRX clearing member, defaulted on certain obligations to the exchange after entering in error over 36,000 orders involving Kospi 200 index options. As a result, HanMag sustained trading losses in excess of KRW 46 billion (approximately US $43.5 million) and failed to pay most of its obligations to KRX as a result of the erroneous trades. KRX ultimately satisfied HanMag’s default from other member deposits in the exchange’s joint compensation fund. (Click here for further information on HanMag’s default in the article “Korean Broker Default Raises Specter of Algorithmic Trades Gone Bad and Broker Liability for Fellow Brokers at Clearing Houses” in the February 17 to 21 and 24, 2014 edition of Bridging the Week.)
Mr. Wetjen cited KRX’s experience with HanMag as an example of the success of the clearing model:
Indeed, one could say that the fundamental framework for loss-mutualization was tested and proved sufficiently resilient at the Korea clearinghouse given the fact that losses of the defaulting securities firm were absorbed, and trading on the exchange resumed relatively quickly.
Notwithstanding, because of recent efforts to increase centralized clearing for over-the-counter swaps, Mr. Wetjen argued that it was important “to be cognizant of, and effectively address, the resulting increased concentration of risk in the cleared space.”
According to Mr. Wetjen, requiring clearinghouses to submit to globally standardized stress tests could help their members and customers better understand their risk profile. However, he cautioned that developing such stress tests and how the results might be disseminated required careful consideration:
For example, if CCPs are required to disclose the assumptions and stress scenarios underlying their stress tests, could this disclosure (together with the other publicly available information) permit someone to reverse engineer the position information of targeted market participants? Could these disclosures be used as a tool for market manipulation? Does disclosing results on an anonymous basis sufficiently mitigate these concerns? Could these disclosures inadvertently damage market confidence? If global regulations are not harmonized, what could be the impact on competition?
Likewise, Mr. Wetjen acknowledged the public debate regarding the potential benefit of requiring clearinghouses to utilize at least a portion of their own capital in the default waterfall should a member fail. He suggested, however, that should the CFTC consider a rule requiring clearinghouse skin in the game, “global harmonization on this point may be appropriate.”
Finally, Mr. Wetjen expressed his view that clearinghouses should develop “clear and detailed” recovery and wind-down plans. These should be designed, he said, “to minimize the contagion risk of the broader market.” He also questioned “whether customer collateral provided by non-defaulting members to a clearinghouse should ever be part of a CCP’s recovery plan through the use of tools such as variation-margin haircutting.”
Mr. Wetjen indicated that he would host a meeting of the CFTC’s Global Markets Advisory Committee—which he chairs—later this winter to address clearinghouse risk management issues.
…While a Clearinghouse—LCH.Clearnet—Weighs in on Clearinghouse Issues Too
LCH.Clearnet published a white paper setting forth its perspective on clearinghouse (CCP) risk management, recovery and resolution, and offered its view on principles that should govern CCP recovery and resolution regimes worldwide.
Among other thing, the clearinghouse supported efforts to develop “standardized stress tests of CCPs’ risk management methodologies and argued that disclosure of the results could help increase confidence in CCPs and identify best practices;” offered that recovery tools should be developed in consultation with clearing members and their clients, be agreed upon in advance, and provide “certainty and transparency” regarding the amount of any contingent liability; and said that CCP resolution “will be most effective if it is led by the resolution authority of the jurisdiction in which the CCP is established.”
However, LCH is opposed to any requirement that CCPs contribute substantially more of their own resources (so-called “skin in the game”) to a member default waterfall other than the 25% of the CCP’s minimum capital requirement as currently required in Europe under the European Market Infrastructure Regulation (there is no equivalent requirement in the United States). According to the clearinghouse,
[a]ny requirement for the CCP operator to contribute significant additional resources to the default waterfall and link them to the overall member exposure would fundamentally change the operator’s risk profile, creating increased risk exposure to member default at the very time that the operator should be resilient in order to ensure continuity of the clearing service and stability of the market.
According to LCH, the first line of defense in a situation of a clearing member default is initial margin. This is why, said the clearinghouse, Dodd-Frank rules require a 99% confidence level for all products, while EMIR requires 99% for cash instruments and listed derivatives, but 99.5% for over-the-counter derivatives. LCH noted that its policy is to apply a 99.7% confidence level across all products.
LCH claims that if CCPs were required to increase their skin in the game, “[i]t would create an incentive for the CCP to minimize the size of the default fund; for example, by increasing initial margin requirements.”
LCH also advocated in favor of “variation margin gains haircutting,” which permits a CCP potentially to reduce across all clearing members variation margin they may be due following the default of another clearing member after prefunded resources have been exhausted. According to LCH,
VMGH is acknowledged to be a powerful recovery tool. It is similar to loss allocation under general insolvency but has the benefit of avoiding the costs and delays associated with insolvency proceedings. It also has an important advantage over an uncapped cash call in that it does not create an unlimited contingent exposure from a clearing member to the CCP. A clearing member can lose no more than the amount by which its position has gained in value since the default.
Finally, to help minimize clearinghouse depository risk, LCH argued that CCPs should be authorized to deposit cash in central bank accounts.
My View: The debate regarding clearinghouse skin in the game and other measures to enhance risk management and controls by clearinghouses has been reaching a crescendo these past few weeks and deserves to be aired formally and publicly—as Commissioner Mark Wetjen of the Commodity Futures Trading Commission promises to do at an upcoming meeting of the CFTC’s Global Markets Advisory Committee. The white paper by LCH.Clearnet evidences that the debate will not be one-sided, and, along with Commissioner’s Wetjen’s remarks before the FIA Asia Derivatives Conference, demonstrates why the imposition of any requirements on clearinghouses must be coordinated globally.