It’s Wall Street’s worst nightmare, a financial collapse that would make 2008 look like a day at the beach.
What if the five or six largest clearinghouse members suddenly defaulted simultaneously? Could clearinghouses manage their resources to meet their responsibilities, and what would happen if they could no longer make good on their members’ losses?
The Commodities Futures Trading Commission (CFTC) has asked a number of industry participants those very questions.
CFTC Chairman Timothy Massad reassures that such an event is strictly hypothetical.
“To my knowledge, no U.S. central counterparty [CCP] has ever had to use resources beyond a defaulting member’s resources to deal with a problem,” he said, adding that this subject needs to be broached. “It doesn’t mean we shouldn’t plan for it and, in fact, our rules require us to plan for it because we know that no matter how good a regulatory regime is, in extraordinary circumstances something could happen.”
A clearinghouse’s entire raison d’etre is to mitigate the default risk by spreading the risk among its members. Each member contributes its initial margin for each trade to the clearinghouse’s guarantee fund, which the clearinghouse taps for additional resources to cover any losses due to a member’s default. A clearinghouse also may levy individual assessments on members whose defaults would bring greater risk to the clearing organization.
If a member defaults on a trade, the clearinghouse would apply that member’s initial margin and guarantee-fund contributions against the loss. If those funds are not enough, the clearinghouse may auction off the defaulting member’s positions to cover the losses.
“DCOs have been able to complete auctions applying only the defaulter’s resources, that is to say the defaulter’s initial margin and guarantee-fund contributions,” said Robert Wasserman, chief counsel at the CFTC.
My, What a Big Black Swan
The default procedures used by clearinghouses have kept their markets open and clearing through all of the recent bubbles and crashes since their inception, but what happens when “the big one” hits?
The clearinghouses first would go through the standard member-default process and provide “incentives” to clearing members to participate actively in the mandatory auction process, suggested Sunil Cutinho, president of CME Clearing.
“How the member firm’s funds would be utilized when losses accrue would be dictated by its participation in the auction and the nature of its participation,” he explained.
“If you are the auction winner, the chances that your guarantee fund gets used first are close to zero,” clarified Rajalakshmi Ramanath, a vice president at JPMorgan Chase. “If you submitted a bad bid, then your guarantee fund gets used up first.”
“The last thing clearing members want to see is a fire sale and have to pay more for their guarantee-fund contribution and assessment rights out to the benefiting party,” added Kevin McClear, general counsel at the Intercontinental Exchange (ICE).
Another step that a clearinghouse might take is expanding the number of firms participating in the auction by including non-members of the clearinghouse to participate.
“We are honestly thinking through what the terms and conditions of direct participation by the buyside would be,” McClear said.
“In this specific context, we think it would be beneficial to expand the auction beyond clearing members,” agreed Kristen Walters, global COO for asset manager BlackRock’s risk and quantitative analysis group.
Clearinghouses also could stem potential bad behavior from indirect members, such as front-running, by asking them to “provide some kind of skin in the game” since they would not have initial margins or guarantee-fund contributions that a clearinghouse could use as leverage, suggested Biswarup Chatterjee, global head of electronic trading and new business development, credit markets at Citigroup. Chatterjee spoke on behalf of the International Swaps and Derivatives Association (ISDA).
If the auctions still fail to cover the remaining outstanding losses of the defaulting members, clearinghouses can apply a mixture of four non-perfect tools to allocate those losses and to cover any liquidity shortfall as long as they have established the appropriate rules for their use prior to the incident, according to CFTC’s Wasserman.
In the first option, clearinghouses could force the allocation of positions that have not been liquidated voluntarily to non-defaulting participants.
The second option would be applying a partial tear-up that would terminate a portion of positions that may be opposite the defaulter’s unliquidated positions, a set of risk-related positions or even an entire product set.
The third option would involve a complete tear-up that would terminate all matched and unmatched positions that are then marked to market; any remaining default resources are used to compensate those with claims in a pro rata manner that is set out in the DCO’s rulebook.
The final, and most controversial, tool available to clearinghouses is a variation margin gains haircut (VMGH). When a DCO decides to apply a VMGH, it continues to collect in full from members with out-of-the-money positions on a daily basis while reducing the amount it pays to members with in-the-money positions in a pro rata fashion.
This option carries less performance risk than cash calls, according to CME’s Cutinho, but its use would be extremely unpopular with the non-defaulting members since they would feel the pain directly on their bottom lines. “It encourages participants to participate in the recovery before we get to the point [of implementing a VMGH],” he said. “Gainers will know that there will be no windfall profits and their profits will be haircutted.”
A VMGH has the added benefit of not targeting members or end-users specifically, according to Phillip Whitehurst, head of capital, collateral and liquidity for SwapClear at LCH.Clearnet. “It targets gainers, but those gains are just as likely to be members as end-users,” he explained. “Our experience is that some of the biggest positions that we hold are from dealers as well as end-users. It is important not to regard VMGH as in some way the exclusive jurisdiction of end-users.”
Despite its egalitarian impact, many in the industry agree that a VMGH solution should be a tool of last resort that only should be used after the DCO has exhausted all of its other financial safeguard options.
“If it is a stage where four or five financial institutions fail and we are starting to cut gains on variation margin, I don’t know what other tools you have in the tool chest,” said Philip Priolo, director of credit at energy firm Exelon Corp.
The use of a VMGH would only be acceptable if there were quantified limitations in its use, according to Thomas Kadlec, president at ADM Investor Services, who spoke on behalf of the Commodity Markets Council.
“For example, would the VMGH affect all commodities or just the commodities in question?” he asked. “Agriculture contracts, which are dear to my heart, most likely do not have the breadth and depth to cause a central-counterparty failure. With certain limitations, I would be supportive of a VMGH, but it would really need to be vetted out in full discussion and limited to specific buckets.”
If after a clearinghouse implements a VMGH it still finds itself lacking the resources to clear all of its supported markets, it may consider suspending clearing for a brief period to calm the markets and bring more capital into the system. There was a four-day trading suspension after Sept. 11, Kadlec cited.
“It brought some stability, gave people time to organize and garnered some confidence,” he said. “It’s a tool that should be used, but not used prominently. The most important thing for a hedger is market continuity, and however we can continue that continuity is what I would look for in support of our customers.”
Fish or Cut Bait
Ultimately, if a clearinghouse cannot weather a stress greater than the 1987 crash, the failure of Long-Term Capital Management and the 2008 credit-market implosion combined, it must decide if it will attempt to recover and recapitalize itself or turn off the lights and wind down the organization.
To recover, a CCP would need to act consistent with its rules and procedures and other pre-existing contractual arrangements to address any uncovered loss, liquidity shortfall or capital inadequacy, according to regulators.
To terminate service as part of a wind-down, a DCO would tear up all existing contracts, mark-to-market the former positions, and pay out its obligations in a pro rata manner or transfer critical services to another legal entity.
Neither is a pleasant option, and the industry is divided on which post-event road a clearinghouse could take.
Two large asset managers, BlackRock and Pacific Investment Management Co. (PIMCO), favor winding down a failed CCP.
“We are without equivocation complete supporters of central clearing,” said BlackRock’s Walters. “In the context of a ‘point of no return’ for a CCP, where it literally exhausted the financial resources it had, in that case, we think that liquidation is a good choice.”
“Believing that financial stability is best served in a market [that would allow] rapid and complete winding down of a failing CCP’s positions, and reducing any timing so that it could repay monies as quickly as possible, would be our preferred approach,” agreed Tracey Jordal, executive vice president and senior counsel at PIMCO.
Yet, not all derivatives clearing is fungible, said Joseph Kamnik, vice president and chief regulatory counsel at the Options Clearing Corp. (OCC): “For options, we are the only game in town.”
Systemically important CCPs that have no alternative, such as the OCC, should have a resolution strategy for their critical functions, just as systemically important financial institutions do, suggested JPMorgan’s Ramanath: “The resolution strategy should focus on continuity of the activities, the critical functions of the clearinghouse rather than the wind-down of the clearinghouse itself.”
Although the CFTC’s hypothetical doomsday scenario likely will not happen, the industry agrees that more work needs to be done to flesh out the various issues just in case.
“Clearly the topics discussed are very important for the industry, and representatives from the buyside, sellside, trade associations, CCPs, supervisors and politicians are actively engaged to review ideas and develop meaningful solutions,” said LCH.Clearnet’s Whitehurst.
To avoid the unthinkable.
