To some outside observers, it may seem like a distant memory that a member of Nasdaq’s Nordic clearinghouse defaulted in September. But the event remains fresh in the minds of many derivatives market participants, and a hot topic of conversation in the industry.

At FIA’s annual Futures and Options Expo in Chicago on Oct. 17 and 18, key members of the clearing ecosystem had their first chance to collectively discuss what happened and why. Panel discussions on the topic of clearing delved deeply into the circumstances of the default. A host of other presentations also touched on the topic, and the issue came up frequently in informal conversations throughout the conference.

That’s because even with some distance from the default itself, the industry is still trying to understand exactly what happened.

It’s not unusual for a trader to be on the wrong side of the market. But what set this incident apart was the fact that the trader’s loss consumed roughly two-thirds of the clearinghouse’s default fund. The fund is typically the last line of defense against a market meltdown, and many industry experts expressed surprise that an individual trader’s default could penetrate so deeply into a clearinghouse’s financial resources.

In addition, banks, brokers, commodity trading firms and other members of the clearinghouse provide the vast majority of the default fund’s resources. That meant that the losses from the default were shouldered primarily by members rather than the exchange, a sore point for the clearing firm community.

Nasdaq President and CEO Adena Friedman acknowledged the default was a "traumatic event," but also "an opportunity to understand the lessons learned to make sure that it never happens again."

"We understand it’s a very rare event, so we need to make sure that we take it extremely seriously and move forward in a much better state," Friedman said on Oct. 17 during a discussion with other exchange leaders in front of several hundred conference attendees.

Nasdaq already has taken several steps to address the situation. It has solicited questions from its members and provided information and insights where possible under its legal and regulatory restrictions. Nasdaq has also enlisted Oliver Wyman, a consulting firm, to review many elements of its operations, including the risk management practices at its clearinghouse, and it has said it will make some results from that review available to the public.

But what are the concerns of other clearinghouses, and how are they responding? And most importantly, how is the derivatives industry planning to protect itself from the next moment of market stress, which will surely look much different than the last?

Here are some highlights from conversations about these topics that took place during FIA Expo.

DETAILS OF THE DEFAULT

Here are the basic facts about the default: On Sept. 10, electricity prices on Nasdaq’s Nordic commodities market experienced an extreme movement as the spread between Nordic and German power widened 17 times more than the average in prior trading sessions.

Einar Aas, a power trader in Norway, was on the wrong side of that move. After he failed to meet an intraday margin call, default procedures were initiated early on Sept. 11.

After recovery proceedings from an auction of the defaulted portfolio, the total loss was 114 million euro. Nasdaq Clearing covered 7 million euro of that shortfall, with the remaining 107 million euro coming from the default fund financed by clearing members. By Sept. 17, the members had fully replenished that fund.

These bare facts do not explain the full complexities of this market event, however, or some of the broader concerns raised by the default. Other noteworthy factors include:

TRADER EXPERIENCE: Einar Aas wasn’t just a rogue 20-something who slipped through the cracks. He was "an experienced trader," said Nasdaq’s Friedman, with more than a decade trading power markets. According to Bloomberg, Aas was wildly successful at trading in power markets prior to his default. In fact, public tax returns from 2016 show he was the single biggest taxpayer in all of Norway. By all accounts, this was a seasoned market participant with a history of with these markets.

MARGIN CALLS: Aas also had a good history of complying with Nasdaq’s margin requirements. Friedman noted that in the months leading up to the default, he had been increasing the size of his position and at the same time increasing the amount of margin deposited at the clearinghouse, as required. "But at the moment that we called the additional capital intraday to bring in more margin against that position, because the spread had widened so much intraday, he was unable to meet his call," said Friedman. "We therefore, according to our rules, seized his position and then [went] through essentially a default management process of auctioning off that position according to our rules."

DIRECT MEMBERSHIP: In part because of his wealth and experience, Aas was a direct member of the clearinghouse, registering transactions in his own name and posting them into his account directly. Although that is allowed under the rules of Nasdaq Clearing, many clearinghouses do not allow individuals to become clearing members. Instead they require market participants to use a clearing firm to process their trades and guarantee their performance.

For Jeff Sprecher, chairman and CEO of Intercontinental Exchange, that raised a red flag. "A single individual without a lot of adult supervision from a third party" raises concerns, Sprecher said during the exchange leaders panel. "[That] took one layer of defense out, in that you had a clearing member that was also overseeing [his own] position," he said.

"Today a bank like Citi is highly regulated with a lot of third parties looking at its capital. And the bank itself is being stress tested and there’s a certain amount of comfort that a bank can resolve itself. And then you put that bank as a member of a clearinghouse [and] you’ve got one level of protection at the clearinghouse. If you put an individual in there, you don’t quite have that same visibility. Should that individual be treated differently than a bank? I think that’s a fair debate," Sprecher said.

MARKET VOLATILITY: The dramatic move in spreads between Nordic and German power was indeed an uncommon event; prior to Sept. 10, the largest daily change in the spread since 2011 was 1.60 euro and the move that resulted in the default was a change of 5.56 euro. However, electricity markets in general are unusually volatile, warned Sprecher, who started his career in the U.S. power markets.

"Power has the ability to really move to almost infinite price because when there’s a blackout or a brownout in our society today we can’t have hospital and traffic lights and what have you not operate. So the local power company will spend almost anything on an instantaneous basis to keep the grid going," Sprecher said. "So you’ve got a complicated market, a single individual without a lot of adult supervision from a third party and the question is, was the margin model right?"

REVISITING RISK CONTROLS

Beyond the specifics of the default, more general questions have been raised about risk management processes that allowed such a situation to transpire to begin with.

Lee Betsill, managing director and chief risk officer at CME Group, stressed that all central counterparties should use the recent default as an opportunity to review whether their risk protocols are sound — regardless of which firms are involved or what they are trading.

"Risk management blow-ups can happen whether you’re a direct clearing member are not, so this all goes back to are you proactively risk-managing your positions and exposures that you’re taking on?" said Betsill at an Expo panel discussion on clearing.

And stepping back, it’s also important to remember that central clearing still works even if there are improvements that can be made in risk controls in the wake of the recent default, according to Erik Mueller, CEO of Eurex Clearing.

"Thee architecture of CCPs shouldn’t be in question. Rather we should look at the calibration on how things have been tried and how the tools work," said Mueller.

Here are a few topics that market participants were debating in regards to broader risk protocols for clearing houses.

IDENTIFYING CONCENTRATION: Size was a key issue that resulted in the September default, said Sunil Cutinho, president of CME Clearing. "This is no different from Amaranth if you look at it the right way, and no different from other cases where an entity or a desk or person takes on a position that’s beyond their capacity," he said during an Expo clearing panel.

Identifying that concentration requires diligence and precision, including looking at liquidity positions relative to the open interest on the market and the nature of underlying assets on a case-by-case basis, Cutinho said.

MARGIN ADD-ONS: After identifying that concentration, deciding how much margin is required to counteract that size is the next step. Hester Serafini, president and CEO of ICE Clear U.S., noted that if her firm had a similar situation as the one that led to the September default, "we would have actually charged a significant add-on because of the size of the position. And that add-on would have actually covered the size of the losses that were actually incurred."

LOWERING MARGINS: Concentration concerns aside, there has been a general trend of clearinghouses demanding lower initial margin across positions of all kinds, said Chris Perkins, managing director and global head of OTC clearing at Citigroup. "I would tell you that outside of this particular CCP, in the space that I’m responsible for, we’ve seen year-over-year that some CCPs are lowering their initial margin by double digits between 2017 and 2018," he said during an Expo clearing panel.

His comments echoed similar concerns raised by other senior clearing firm leaders before the default. According to data compiled by JP Morgan and reported in Risk magazine in September, there have been 13 significant margin breaches in 2018 across listed derivatives markets.

JP Morgan’s head of clearing, Nick Rustad, called for changes to clearinghouse margin practices as a result of this worrisome trend.

"The concern is, under the systemic changes that have been applied since the crisis, we haven’t seen all these asset classes be volatile at the same time," he told Risk. "If that did happen, which wouldn’t be a black swan event, we would be running a greater risk of client default, which risks a clearing member default — and, in turn, risks a CCP default."

MARGIN TRANSPARENCY: Recent events have obviously highlighted substantial differences in how individual clearinghouses set margin requirements. That may demand greater outreach and communication on behalf of CCPs to ensure members are prepared — particularly in times of market stress. "We’ve been advocating for a number of years now to make margin models transparent to allow the market participants to replicate how you calculate it and to have a much better tool to predict [additional margin] if there are certain events happening to the market," said Matthias Graulich, chief strategy officer and executive board member at Eurex Clearing.

Graulich added that around the initial Brexit vote, Eurex "communicated in advance and people had a chance to prepare" for market volatility and resulting changes to their margin.

RECOVERY AND WATERFALLS

After questions about how one trader managed to take on such a large position and whether there was enough margin in play, there are also questions about the recovery process in the wake of the September default.

Part of the debate centers around well-worn issues such as "skin in the game" and the particulars of default waterfalls. But many in the industry also question the nature of the recovery process meant to minimize total losses before any clearinghouse or member funds were required. Here are some of the concerns heard at Expo:

AUCTION PARTICIPATION: According to Nasdaq’s public comments, the close-out process involved six clearing members with four of those members invited to bid on the defaulted portfolio in a closed auction. Some were concerned the small number of invitations indicated a breakdown in the recovery process and a failure to realize maximum value from the defaulted portfolio. Serafini noted ICE allows non-clearing members to bid, as well as the ability to "require" bids from members by changing their individual priority in the waterfall. "If they don’t bid, their guarantee is juniorized and is used before that of other clearing members who bid in the auction process," Serafini said.

POTENTIAL BIDDERS: Some also wondered whether the lack of bidders was because there simply weren’t enough participants with the ability to take on the assets. Most major clearinghouses are now held to a "cover 2" standard, meaning that they have to have enough financial resources to withstand the simultaneous default of their two largest members. But some experts wonder if the remaining members will be willing to absorb the positions of a defaulting member. Banks now face large capital requirements on their clearing business and some have actually been shedding customers in order to reduce their capital requirements.

"If you say you are a cover 2… that implies that 4, 5, 6, 7, 8, 9 and 10 have the capacity to absorb the positions," said John Davidson, president and COO of the Options Clearing Corporation. Acknowledging the regulatory capital constraints of clearing members who would be asked to bid is crucial to acknowledging how a potential auction process would take place in the real world, Davidson said.

Travis Nesmith, a risk management expert at the U.S. Federal Reserve, echoed this concern. Nesmith said during an Expo discussion on clearing that risk models developed by the clearinghouses need to factor in the number of clearing members that can bid for large positions. "If there are a limited amount of people who can take down a portfolio of this size that you’re clearing, that needs to feed back into all your risk management steps going forward," he said.

PRACTICING AUCTIONS: Graulich noted that Eurex Clearing has regularly engaged in "fire drills" to practice the default and recovery process, and that it wasn’t always a pleasant exercise. "I remember that the first fire drills were really hard," he said. However, over time the clearinghouse refined its process and was able to respond more quickly to scenarios. "I think this only works if you have practiced," Graulich said. "It’s very important to be robust and sound in this process, because at the end this is what determines the price that will be realized for a defaulted portfolio, which at the end determines how big are the losses."

DEFAULTER PAYS: Some like Chris Perkins, global head of OTC clearing at Citigroup, think recovery models should be recalibrated so that the defaulting party is on the hook for any losses incurred, and other clearing members provide support through a default fund only in the event of "extreme tail" events. The recent Nasdaq Clearing default shows "a fundamental breakdown" in that model, Perkins said at Expo. "Yes, clearing is the socialization and mutualization of risk among its members, but that should very rarely happen. In this case, we know from public sources that we saw 107 million euros in total losses that were spread out across 166 clearing members. That’s not defaulter pays."

OCC’s Davidson commented that the industry needs to find the right balance between two models: one where the defaulter covers the entire loss, and one where the loss falls on everyone else, which he called the "survivor pay" model. "Margin is clearly a defaulter pay model. The clearing fund, which is the neutralization of the risk of the CCP by all the clearing members, is a survivor pay model," said Davidson. "There is clearly a balance decision to be made about the right level of defaulter pay and the right level of survivor pay."

LIMITS TO SKIN IN THE GAME: While admitting substantial skin in the game is needed "to create the alignment of incentives," Graulich of Eurex Clearing warned certain formulations would have a chilling effect on clearing as a whole. He noted a suggestion that CCPs stand behind 10% of the default fund in the first line would be cost-prohibitive, equating to "two years of profits" for his firm. If such substantial requirements become common practice, "nobody would want to be the manager of a CCP,"Graulich said.

Those comments were echoed by Terry Duffy, chairman and CEO of CME Group, who warned against a "moral hazard" by asking exchanges to put up a tremendous amount of capital as the first line of defense against losses. That could create a situation where "somebody can literally take a swing at you, especially since you’re first in line" to absorb a loss, he said. He acknowledged, however, that the cost of absorbing a default could have a damaging impact on smaller clearing firms, particularly in the agricultural sector. "They share in these defaults, and they can’t take on these losses if somebody was to hit them hard," Duffy said.

WHAT’S NEXT?

While many details of the Sept. 11 default are not yet public, Nasdaq’s Friedman has been vocal about how the exchange plans to explore what went wrong, and plans to share those findings with members and regulators so that the entire industry can learn and improve.

"We’ve hired Oliver Wyman to come in and make that assessment with us, and they are looking at every element of what we do—our margin obligations, our margin rules, all of our risk management protocols, our governance, our clearing member requirements, every element of how we operate the clearinghouse to see where we can find opportunity for improvement," Friedman said at Expo.

For its part, FIA is also involved in broader discussions with the industry to "bring the community together" and share lessons learned from the incident, said President and CEO Walt Lukken in remarks at Expo.

"FIA has been working with Nasdaq Clearing to understand the recent clearing member default, and to determine what changes to risk management may be needed to prevent similar defaults from occurring in the future," Lukken said.

But no matter how rigorous the investigation into the September incident or how well-intentioned the response, there will always remain questions about whether the current risk management protocols and default management tools are adequate.

That’s because there are no easy solutions when it comes to the balance of managing risk while maintaining a robust market for derivatives, said Jerome Kemp, global head of futures, clearing and collateral at Citigroup and chairman of FIA.

"There needs to be a realization that for these markets to evolve, we are all bringing risk and managing risk as an ecosystem," Kemp said. He added that this demands striking a delicate balance between the needs of clearinghouses and their members.

"We’re all in this game together," Kemp said at FIA’s Expo. "I think it’s a very artificial divide to try to play this off as who brings the risk to the table and who manages the risk; it’s a false debate."

It’s also important to acknowledge that while events in September were cause for serious concern and worthy of reflection, they are also in some ways a validation that "the system works," said Sprecher.

"To the outside consumer, no taxpayer money came in," Sprecher said. "But between us, as an industry, did we handle that person right and did we allocate his loss properly? That is the second part of the equation."