22 August 2014

63425

Jennifer Liu - Capco

12 | posts 40,113 | views 0 | comments

Risk management is a vital benefit of CCP clearing

27 November 2012  |  5266 views  |  0

In the trade life cycle, central counterparties (CCPs) play a critical role in post-trade management.

After a trade has been negotiated, submitted and confirmed, a CCP takes on the counterparty risks by standing between two counterparties through novation, nets offsetting transactions between multiple counterparties, and provides ongoing risk and collateral management until the end of the transaction’s term. Typically, a CCP calculates margins and conducts margin calls to its members, requiring collateral deposits for the margins. It independently conducts valuation of the trades and collateral, and monitors the credit worthiness of the counterparties.

CCPs also provide members with reports that detail the transaction information, novation status, netted positions and margin information. The reports can be used by the back office and risk management team in the participating firms to perform reconciliations and cover the resulting margin calls.

Risk management is the core function of CCPs. In addition, some CCPs offer other services such as delivery management (e.g., ICE Clear U.S., EurexClearing) and transaction management (e.g., Eurex Clearing, FICC), providing clients with a seamless post-trade experience. With the services that CCPs provide, clearing house members can enjoy the benefit of lower settlement costs, increased operational efficiency and reduced risk through robust risk management.

A key differentiator for CCPs to distinguish themselves from their competitors, besides their individual service offering, is the breadth and depth of products they clear. For example, CCPs such as LCH.Clearnet cover a wide range of products, including derivatives, commodities, equities, fixed income, foreign exchange and other products, for both exchange trades and over-the-counter (OTC) transactions. Some CCPs that only focus on certain asset classes are able to offer more variety. For example, within credit derivatives, some CCPs only offer CDX clearing (CDX is an index on credit default swaps, or CDS), whereas others offer both CDX and single-name CDS clearing. In addition, within each product, some CCPs have the advantage of clearing more currencies than others.

Unless properly managed and well capitalized, the CCPs can potentially pose significant systemic risk to the market, with the concentrated risk that they take on. There have been heated discussions about the vulnerability of CCPs in distressed market situations. Some even start to apply the term “too big to fail” to CCPs. How do CCPs usually manage their risk and what is the sequence of events when a participating member defaults?

Using credit risk management as an example,[1] CCPs first ensure that only firms of a certain size can participate in the CCP clearing. Before a firm can join, it needs to meet membership requirements, including the size of capital and default fund contribution (more details about membership requirements will be discussed in next week’s blog on CCP participation). Once members begin clearing transactions through the CCP, the CCP will calculate margins, which usually include initial margin (IM) and variation margin (VM) on transactions. The Standard Portfolio Analysis of Risk (SPAN) methodology[2] is widely adopted by CCPs to analyze risk scenarios and calculate margins. To cover the margins, firms need to post collaterals, either cash or securities deemed eligible by the CCP, which are usually high-quality and highly liquid financial instruments such as government bonds.

In the event of a member default as defined in the CCP default rules (e.g., fail to settle, fail to post margin, fail to pay fees), the CCP can claim the member to be in a non-conforming or default status. It then follows its default rules and procedures. For instance, the CCP may seize the default member’s assets, and then either transfers the assets to another member or auctions the portfolio to other members. To cover the induced loss from the default member, the CCP’s first recourse is to seize the default member’s resources, including the collateral it pledged for margins and its contribution to the default fund. If the above resources are not sufficient to cover the loss, the CCP will look to its own capital reserved for this purpose and then the remaining default fund contributed by members still in good standing.[3]

Even though the market has not witnessed a massive meltdown of CCPs and its paralyzing effect, regulators are taking precautions. For example, European regulators in September 2012 unveiled proposals that will force clearing houses to hold more capital. As more spotlights are shone on CCPs, it will not be a surprise to see more regulations related to CCPs proposed.

Do you think CCPs’ default rules and procedures provide adequate protection in a distressed market? Join the discussion.

Next week, the CCP blog series will focus on who can participate in CCPs, how they can participate and key considerations when choosing to participate in a CCP.

 

[1] CCPs need to manage other risks as well, such as liquidity risk, operational risk, legal risk, etc.

[2] http://www.cmegroup.com/clearing/risk-management/span-overview.html

[3] All CCPs publish their default rules and procedures in great details on their websites.

TagsTrade executionPost-trade & ops

Comments: (0)

Comment on this story (membership required)
Log in to receive notifications when someone posts a comment

Latest posts from Jennifer

Central Clearing calls for effective collateral management

13 January 2014  |  2314 views  |  0  |  Recommends 0 TagsTrade executionPost-trade & ops

How dark are the pools? - Part 3

02 May 2013  |  2134 views  |  0  |  Recommends 0 TagsTrade executionPost-trade & ops

How dark are the pools? - Part 2

25 April 2013  |  2760 views  |  0  |  Recommends 0 TagsTrade executionPost-trade & ops

How dark are the pools?

18 April 2013  |  2508 views  |  1  |  Recommends 0 TagsTrade executionRisk & regulation

Bringing shadow to light

19 March 2013  |  1523 views  |  0  |  Recommends 0 TagsRisk & regulation
name

Jennifer Liu

job title

Business consultant

company name

Capco

member since

2012

location

Toronto

Summary profile See full profile »

Jennifer's expertise

What Jennifer reads
Jennifer writes about
Jennifer's blog archive
January 2014 (1)2013 (5)2012 (6)

Who is commenting on Jennifer's posts