How clearing houses aim to avert market disasters
In the last past decade global authorities have promoted elevated the role and importance of CCPs as
Clearing houses have been cast into the spotlight after soured bets from Norwegian trader Einar Aas blew a €114m hole in the buffers that are designed to stem systemic losses from trading derivative contracts in the European power markets.
In the past decade global authorities have elevated clearing houses as central pillars of market stability. This in turn has raised concerns that these utilities are the new “too big to fail” institutions.
For some the episode is a perfect example of a system working as intended after the financial crisis. For others, it is a sober warning of what could go wrong in stressed markets.
“The reserves clearing houses put in place are calculated according to the probability of trades like this happening,” said Stephen Connelly, an associate law professor at the University of Warwick. “In this case the clearing house has taken a huge hit from Mr Aas’s trades and may not be able to take another such hit if a similar event asks tomorrow.”
How clearing houses aim to avert disaster
A clearing house stands between two parties in a trade and helps manage the credit risk to the counterparty if one side defaults on payments. Any position it takes on with one party is offset by an opposite position taken with a second party. In normal circumstances the clearer avoids taking on the risk when there is a change in the market value of the trades they enter into.
But when a counterparty can no longer support its trades, the clearing house is exposed on those outstanding contracts.
The first layer of defence begins before it is too late. The clearing house demands more margin, or insurance, from the struggling party or the market, to cover any potential losses. This happened in the eurozone debt crisis when London’s LCH raised the margin on trading several European sovereign bonds.
This is the biggest shield and usually suffices in most cases. The margin of the defaulter covers any losses caused by the clearing house closing out the positions. Defaulted positions can also be transferred or auctioned off to other solvent members of the clearing house.
But the size of Mr Aas’s position on the European power markets meant there was not enough margin at Nasdaq Clearing. Even a late transfer of $36m from Mr Aas was not enough to cover the widening losses.
For a clearing house, this is a rare occurrence. By comparison LCH used around a third of the $2bn of initial margin it had called from Lehman Brothers in 2008 to close its positions.
Layers of protection
If margin calls fail to cover the losses from the defaulter, there are broadly three resolutions on offer:
Capital from the clearing house
A mutual default fund made up of contributions from clearing members
Other resources from the clearing house, such as capital from its parent company
Mr Aas’s positions burnt through Nasdaq’s own capital of €7m, which is likely to reignite a debate between clearing houses and its biggest members, the banks, over a clearing house’s “skin in the game”. Banks such as JPMorgan have long called for clearing houses to include more of their resources as a backstop.
After that, the Nasdaq turned to the default fund consisting of contributions from all clearing members to share extreme losses. It acts like insurance for unforeseen market events. Nasdaq allows institutions and traders to become a clearing member if they have at least €1m in equity to support themselves.
Shared losses
It was this layer that cushioned the impact from Mr Aas’s trades, although the losses used up two-thirds of the default fund.
After the financial crisis regulators toughened the rules over how much resources clearing houses should hold. They demanded the biggest and most systemically important clearing houses in Europe should hold enough resources to meet the losses that could arise from the default of their two largest clearing members in extreme but plausible market conditions.
The pre-funded financial resources at UK clearing houses totalled around £120bn on average in 2016, according to the Bank of England.
In the case of Lehman Brothers, the default fund was not required and so all the counterparties to Lehman’s trades did not incur a loss. Not so with the members of Nasdaq Clearing. For example Fortum, a Finnish energy company, said on Friday it had lost around two-third of its €30m contribution to the fund.
As clearing houses are required to replenish the fund as soon as possible, its members have to pay up before Monday morning. Members like Fortum will have to find €20m while others will demand to know how a single private trader managed to inflict a loss on them.