Central counterparties

On 15 September 2008 Lehman Brothers filed for bankruptcy with a swap portfolio of about $9 trillion notional at one clearing house, LCH.Clearnet's SwapClear: 66,390 trades in five currencies. SwapClear hedged the portfolio and auctioned it to other members in under three weeks, and the cost came out of Lehman's own margin. No other member lost a penny. A year later the G20 decided that standard OTC derivatives should be cleared through central counterparties.

A central counterpartyCentral counterparty: a clearing house that becomes the buyer to every seller and the seller to every buyer for the trades it clears. (CCP) stands between the two sides of every trade it clears. When two clearing membersA firm, usually a bank, admitted to a CCP. Only members face the CCP directly; others clear through a member as its clients. agree a swap, it is novatedReplacing one contract with two: the trade between two members is torn up and each faces the CCP instead.: replaced by two swaps, one between each member and the CCP. The CCP has no market risk, since its trades offset exactly, but it has counterparty risk to every member. Each member has one counterparty instead of many.

The book's illustrative clearing house, Wexcombe Clearing House, clears sterling interest rate swaps (SONIA). Its five members and their positions, as PV01 (£ per basis point rise in rates):

Multilateral netting

Bilaterally, each pair of members would have its own netting set (L3.4.04: Netting). After a 100bp rise in rates, the positive exposures across all the pairs would add up to £153m. Cleared, each member has one net position against the CCP, and what the CCP owes the members who gained adds up to £103m. Multilateral nettingNetting each member's trades with all other members into one position against the CCP, rather than pair by pair. removes 33% of the exposure before any margin is counted.

Margin, tighter and one way

Every member pays or receives variation margin in cash at least daily, often more. Each also posts initial margin to the CCP, which posts none back. Under the EU's rules for CCPs (EMIR), IM must cover 99.5% of moves for OTC derivatives (99% for other products) over a liquidation period of at least five business days for OTC derivatives (two for others), using at least twelve months of history. The shorter horizon than the bilateral ten days reflects how quickly a CCP can close out a defaulter. Wexcombe Clearing House uses a normal model at the book's 90bp rate vol: the 99.5% five-day move is 32.8bp, and IM is that times the member's PV01. Client positions are margined in their own accounts.

The default fund and Cover 2

Margin is set at a 99.5% move; a crisis can be bigger. For that, members contribute to a default fundDefault fund: a pool of contributions from all clearing members, used to cover a defaulter's losses beyond its own margin.. EMIR requires that the default fund and the CCP's other financial resources cover at least the default of the two members to which it has the largest exposures under extreme but plausible market conditions: Cover 2The rule that a CCP's default fund and other resources must cover the default of the two members to which it has the largest exposures, under extreme but plausible market conditions.. Wexcombe Clearing House's extreme but plausible scenario is a 100bp move either way:

The requirement is the larger, £69.23m. The CCP rounds up to a fund of £70m, shared between members in proportion to their initial margin.

The default waterfall

EMIR fixes the order in which a CCP uses its resources (Article 45). The default waterfallThe order in which a CCP uses its resources to absorb a defaulting member's losses.:

1. the defaulter's initial margin;
2. the defaulter's own default fund contribution;
3. the CCP's own dedicated resources, its skin in the gameSkin in the game: the CCP's own capital, committed to the waterfall after the defaulter's resources and before the surviving members' contributions., at least 25% of its minimum capital under EMIR's technical standards;
4. the surviving members' default fund contributions;
5. assessmentsA call on surviving members for further funds after their default fund contributions are used up, usually capped. on surviving members, capped in the CCP's rules, then the CCP's recovery tools (L3.4.09: The risks CCPs bring).

Put the Cover 2 scenario to the test: Ravensholt and Corriemoor default as rates rise 100bp. Their losses are £103m; their initial margin covers £33.77m, their own contributions £32.83m, the CCP's capital £5m, and the surviving members' contributions the last £31.40m. The fund holds. At +150bp the losses are £154.5m: the survivors' fund and a full round of assessments are used up and £8.56m is left for the recovery tools.

Default management

A CCP does not wait for markets to settle. Its default management process, tested in regular fire drills, runs like this:

What must be cleared

After the 2009 G20 commitment, jurisdictions imposed clearing obligationsA legal requirement to clear certain classes of standard OTC derivatives through an authorised CCP, for firms above set thresholds. on standard trades between firms above set thresholds. In the US, the first swaps had to be cleared from 11 March 2013; in the EU, standard interest rate swaps in euro, sterling, yen and dollars from 21 June 2016 for the first category of firms. Physically settled FX forwards and swaps were exempted in the US in November 2012. UK pension schemes have a clearing exemption that the UK has extended indefinitely; the EU's equivalent expired in June 2023.

Saltney's £80m swap (T7) would depend on whether the fund is a financial counterparty above the clearing threshold. The book keeps all its trades bilateral, so that earlier lessons could use them.

Let member $i$ have house PV01 $P_i$ (£ per bp; positive gains when rates rise), and let the CCP's margin model use a normal rate vol $\sigma$ bp a year.

Initial margin. At confidence $q$ over $h$ business days:

Netting. With $P_{ij}$ the PV01 of $i$'s trades with $j$ and a move of $\Delta$ bp:

Cover 2. With $L_i(s)$ member $i$'s loss under stress scenario $s$, and $U_{(1)} \ge U_{(2)} \ge \dots$ the uncovered losses sorted:

The waterfall. For a set of defaulters $D$ with loss $L = \sum_{i \in D} L_i$, each layer takes what is left, up to its size:

Strictly, layers 1 and 2 apply defaulter by defaulter: one defaulter's surplus margin does not cover another's loss. Survivors share layers 4 and 5 in proportion to their contributions; $c$ is the assessment cap, here 1× the contribution.

Choose who defaults and how far rates move over the close-out. Rates up hurts the members that receive fixed (negative PV01), rates down the payers. Try a single default, the Cover 2 pair, and a move beyond the 100bp stress.

The bank clears T3 (pay-fixed £250m, ten years) and T4 (receive-fixed £150m, five years) at Wexcombe Clearing House. The FX forward T5 stays bilateral with Corriemoor.

In the EU and UK, CCPs are authorised and supervised under EMIR: margin (Article 41), the default fund (Article 42), Cover 2 (Article 43), the waterfall (Article 45) and porting (Article 48), with details in Commission Delegated Regulation 153/2013. Banks hold capital against their trade exposures to a CCP and their default fund contributions, at much lower weights for a qualifying CCP than for a bilateral counterparty (M4.4: Counterparty, operational and large exposures). What concentrating risk in a CCP does to the system, and what happens when a waterfall runs dry, is the subject of L3.4.09: The risks CCPs bring.

• A CCP novates each trade into two, one with each member. Members face one counterparty; the CCP faces all of them and has no net market risk.
• Multilateral netting: on the illustrative CCP, £153m of bilateral exposure becomes £103m after a 100bp move.
• IM at a CCP is one way, from members, at 99.5% over at least five days for OTC derivatives under EMIR; variation margin moves daily in cash.
• Cover 2: the default fund must cover the two largest uncovered stress losses; here £69.23m, rounded to £70m.
• The waterfall: defaulter's IM, defaulter's contribution, the CCP's skin in the game, survivors' contributions, assessments, then recovery tools.
• Clearing T3 and T4 costs the bank £4.46m of IM and £4.34m of default fund, and splits its netting set with Corriemoor.

Central counterparty (CCP)

Central counterparty: a clearing house that becomes the buyer to every seller and the seller to every buyer for the trades it clears.

Novation

Replacing one contract with two: the trade between two members is torn up and each faces the CCP instead.

Clearing member

A firm, usually a bank, admitted to a CCP. Only members face the CCP directly; others clear through a member as its clients.

Multilateral netting

Netting each member's trades with all other members into one position against the CCP, rather than pair by pair.

Default fund

Default fund: a pool of contributions from all clearing members, used to cover a defaulter's losses beyond its own margin.

Cover 2

The rule that a CCP's default fund and other resources must cover the default of the two members to which it has the largest exposures, under extreme but plausible market conditions.

Skin in the game

Skin in the game: the CCP's own capital, committed to the waterfall after the defaulter's resources and before the surviving members' contributions.

Default waterfall

The order in which a CCP uses its resources to absorb a defaulting member's losses.

Assessment

A call on surviving members for further funds after their default fund contributions are used up, usually capped.

Porting

Moving a defaulting member's client positions and their margin to another member, so the clients' trades survive.

Default auction

Selling a defaulter's hedged portfolio to the surviving members, who bid for it, as the last step of default management.

Clearing obligation

A legal requirement to clear certain classes of standard OTC derivatives through an authorised CCP, for firms above set thresholds.