On May 1, the Commodity Futures Trading Commission released a report on tests that it conducted on the financial resources held by two large clearinghouses to cover losses arising from a member default. The tests, which were based on data collected in 2018, were part of the agency’s ongoing program to ensure the resiliency of the clearing system and its ability to absorb extreme market movements.
In contrast to previous supervisory stress tests conducted by the CFTC, this set of tests was limited to futures and options cleared at CME Group and interest rate swaps cleared at LCH. One test, called a “reverse stress test,” sought to identify the scenarios that would generate losses so large that they would exhaust the clearinghouses’ resources. The other analyzed the cost of a member default with particular attention to the cost of liquidating the member’s positions.
The reverse stress test used actual market data from four episodes of extreme volatility: the default of Lehman Brothers on Sept. 15, 2008; a large decrease in U.S. equity prices on Nov. 20, 2008; the Brexit vote on June 24, 2016; and a large increase in U.S. equity volatility on Feb. 5, 2018. The test then examined the potential losses from member defaults in three scenarios: one with the same market moves that occurred on those four dates, one with market moves twice as large, and one with market moves five times as large.
The liquidation stress test measured the ability of the two clearinghouses to absorb an extreme but plausible increase in liquidation costs. Those costs include adverse market movements after the default that reduce the value of the defaulting member’s positions as well as the cost of hedging the defaulted member’s positions during the time needed to close out those positions or sell them in an auction. Neither test revealed any serious weaknesses in the financial protections maintained by the clearinghouses. The reverse stress test found that CME and LCH have sufficient pre-funded resources to cover losses under the four historic scenarios even if all of their clearing members with losses defaulted. The liquidation test demonstrated that both CCP would have sufficient pre-funded resources to cover liquidation costs in an extreme market scenario, even if the liquidation cost was twice as much as expected.
In the most extreme scenario considered in the reverse stress test, one with market shocks five times the size of those experienced on the day following the Lehman Brothers bankruptcy, only two clearing members experienced losses greater than initial margin at CME and LCH concurrently. If both clearing members defaulted, the combined shortfall would have been slightly greater than prefunded resources at both clearinghouses, the CFTC said. But even in that scenario, the clearinghouses would have access to additional resources, namely their assessment powers, that were not considered in the CFTC’s analysis.
For both tests, the CFTC’s definition of pre-funded resources consisted of initial margin posted by the defaulting member, the clearinghouse’s own capital, and the contributions by all clearing members to the default fund. At both clearinghouses, the default fund represented more than 95% of the pre-funded resources. This was the third in a series of supervisory stress testing exercises and resulting reports on clearinghouses conducted by the CFTC. Previous stress testing reports were issued in 2016 and 2017.