Since the collapse of Lehman Brothers in 2008, policymakers’ and legislators’ focus on the topic of clearinghouse resilience, recovery and resolution has been intense, with many experts and commentators warning of yet more severe consequences for the financial system should a central counterparty ever have issues or even go into default.
CCPs generally have a number of lines of defense in place to manage defaults without disrupting the wider financial markets. Furthermore, CCPs are obliged to test their default management procedures on a regular basis. For instance, this year Eurex Clearing, CME and LCH are conducting a joint ‘fire drill’ to test how their procedures perform when a firm that is a clearing member of all three CCPs defaults.
The European Market Infrastructure Regulation provides rules on how to manage the process for the default of clearing members. EMIR aims to ensure that CCPs are extremely robust and default-protected market infrastructures. The overriding goal in a default event is to minimize negative effects on non-defaulted clearing members, clients and the wider market while ensuring that the CCP can return to a matched book.
As an EMIR-authorised CCP, Eurex Clearing has implemented the requirements of the legislation and added its own reinforcements. This article takes a detailed look at the lines of defense at Eurex Clearing to show how the default management process would work in practice.
The keystones are initial margins as the main credit risk mitigation tool and the concept of loss mutualization through contributing to the default fund. The default fund serves as a safeguard to reduce the negative impact on the clearing community arising from the clearing member default. Eurex Clearing operates a default fund to which all its members contribute. Eurex Clearing itself also contributes to the fund, and, beyond that, its own equity will be potentially at stake in a default situation. This ensures both the CCP and surviving members have the proper incentives to jointly execute the process.
In the normal course of business, a CCP acts as the buyer to every seller and seller to every buyer for the markets which it clears. As such, the CCP interposes itself between the original parties of a trade, guaranteeing that the trade is fulfilled. If a counterparty defaults, the CCP undertakes the obligations towards the remaining party. This is the basic risk mitigation function of a CCP, which the broader risk mitigation is built around. The default management process consists of the actions taken by the CCP should a member default, leaving it unbalanced with the obligation towards non-defaulting members.
Eurex Clearing’s default management process comprises a set of clear procedures designed to facilitate the orderly liquidation of even large and complex portfolios. To ensure a smooth and timely liquidation of all open positions, Eurex Clearing has staff with trading expertise available at any point in time. In addition, the process facilitates a quick and smooth transfer of clients and their positions from an insolvent clearing member to another solvent clearing member, wherever possible.
The process is designed in a way that enables Eurex Clearing to handle portfolios in different liquidation groups individually. Liquidation groups are sub-portfolios comprised of cleared products that belong to the same asset class and share the same risk characteristics.
The steps listed below describe the key components of Eurex Clearing’s default management process:
1. Default Management Committees (DMC): DMCs convene to support Eurex Clearing through the entire default management process. Each DMC advises and assists the CCP with respect to any relevant aspect of the process, including most importantly hedging of the portfolio and the preparation of auctions, where appropriate. The DMC consists of representatives from clearing members with sufficient trading expertise for a specific liquidation group. This type of governance structure is widely employed by CCPs. The concept depends on support by major clearing members during a crisis and is often discussed among CCPs, regulators and market participants. It requires detailed alignment in order to ensure that critical staff from market participants are available during a crisis. Therefore, Eurex Clearing considers availability of its own trading staff crucial in order to deal with a crisis situation. Its own traders supervise the DMC and work jointly towards rebalancing the CCP.
2. Hedging: The purpose of hedging within the default management process is to reduce market and potential cash-flow risks for the positions of a defaulted clearing member that cannot be liquidated. Furthermore, hedging reduces the portfolio’s sensitivity to market moves and stabilizes it for possible auctions. Hedging of the defaulted clearing member’s portfolio should be implemented as early as possible, so that any potential losses are immediately limited. A hedged portfolio is more likely to receive better prices in the auction.
3. Independent sale: To provide some flexibility during a default, positions or groups of positions can be sold independently to individual market participants as an alternative to the auction process. If the portfolio is small or if only a few clearing members are active in the products concerned, bilateral or on-exchange trades can ensure a timely liquidation.
4. Auction: The liquidation group specific auction is a primary tool of the default management process. An auction enables Eurex Clearing to transfer risk rapidly in bulk to those clearing members willing to absorb it, establishing fair and mark-to-market prices for any given portfolios. Participation in the auctions is generally mandatory for those clearing members who are active in the respective liquidation group. Clients and customers are also allowed to participate, with permission of the relevant clearing member.
Lines of Defense
In case of a clearing member default, Eurex Clearing has multiple security layers (lines of defense) protecting the clearinghouse and its members and ensuring the stability of the financial system as a whole.
The first two layers comprise financial resources provided by the defaulted clearing member. In particular, the defaulter’s initial margin, which was deposited as collateral for open positions, is the first and main line of defense, followed by the default fund contribution of the defaulting clearing member.
In addition, the lines of defense include further layers:
- Eurex Clearing’s own financial resources
- Default fund contributions of all non-defaulting clearing members
- Assessments of non-defaulted clearing members’ default fund contributions together with further contributions from Eurex Clearing
- The parental guarantee provided by Deutsche Börse AG
- Eurex Clearing’s remaining own capital
Segmented Default Fund
Eurex Clearing has a segmented default fund consisting of multiple liquidation group-specific default fund segments. The sum of all DFS constitute the total default fund.
When liquidating a particular portfolio, only funds of the DFS assigned to the respective liquidation group may be used to cover losses, unless there is a known surplus from other liquidation groups for which the default management process has already been finished.
Eurex Clearing has a right to request clearing members to refill their default fund contributions once the pre-funded contributions have been exhausted. In any crisis situation, each clearing member is only obliged to provide additional funds up to an amount of two times its pre-funded default fund contribution. Eurex Clearing participates with an own contribution to each of these assessments providing a further barrier to financial contagion.
Closure of Liquidation Group
As a matter of last resort, Eurex Clearing also reserves the right to close any individual liquidation group at the end of the lines of defense, while leaving all other liquidation groups unaffected. This additional recovery option serves to minimize contagion risk to the maximum possible extent and to ensure continuity for other functioning market segments.
Case Study: How Eurex Clearing Coped with a Real-Life Default
How it unfolded:
Saturday, Feb. 6, 2016: The German federal financial supervisor declares a moratorium on payments and disposals by Maple Bank GmbH, the German subsidiary of Maple Financial Group, a Canadian investment bank.
Sunday, Feb. 7, 2016: The default management team is called in to prepare for the liquidation. The team follows a clear and transparent legal framework, as rehearsed in past fire drills.
Monday, Feb. 8, 2016: Eurex Clearing starts the actual liquidation of the portfolio, closing 93% by end of business the same day.
Wednesday, Feb. 10, 2016: The default process is finalized, with only a small fraction of the defaulter’s initial margin used.
This case provides some important real-life lessons for the default management within Eurex Clearing.
Firstly, it underlined the fundamental robustness and resilience of the CCP, particularly in volatile market conditions.
Secondly, it showed that having a team of highly skilled traders and a well-established network of trading contacts is critical to ensure a smooth and timely liquidation of the portfolio at market prices.
Thirdly, customer account segregation is essential in order to minimise disruption to end users and the wider market.