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Team or Enterprise Premium FT. Pay based on use. Does my organisation subscribe? Group Subscription. Liquidity risks. By substituting itself as counterparty to its clearing members, the clearing house exposes itself to liquidity risks; it must fulfil its payment obligations to non-defaulting members on schedule, even if one or more members default. Indeed, it is particularly critical that a clearing house perform its obligations without delay so that questions about its solvency do not arise. Depending upon the design of the clearing arrangements and the functions it performs, the clearing house may obligate itself to make a wide variety of payments: pass-throughs of profits on outstanding contracts, pass-throughs of option premium payments, reimbursements of cash initial margins, or payments for deliveries.
In the event of a default, a clearing house would typically look to assets of the defaulting member and its own financial resources to raise the necessary funds. However, because clearing houses typically seek to minimise the opportunity costs of membership, in most cases few of these assets are cash assets Non-cash assets must be liquidated or pledged before the clearing house can meet its obligatory transactions, which may be difficult or costly to complete in the time required.
Furthermore, for clearing houses that effect settlements in multiple currencies, foreign exchange transactions might also be necessary to convert the proceeds of such borrowings or asset sales into the required currency. Principal delivery risks. Clearing houses can incur large credit exposures on settlement days, when the full principal value of transactions may be at risk.
This can occur if upon maturity futures or exercise or expiration options contracts are settled through delivery and delivery versus payment DVP is not achieved.
If a commodity or underlying instrument is delivered prior to receipt of payment, the deliverer risks losing its full value. If payment is made prior to delivery, the payer risks losing the full value of the payment. In some cases, the sequence in which deliveries and payments will occur is known in advance and principal risk is clearly asymmetric. Many products traded by derivatives exchanges call for cash settlement rather than delivery, and principal risk is thereby eliminated.
These cash settlements are generally handled through the same channels as other cash payments. In these cases, where a DVP mechanism is not available clearing houses have used other techniques prepayment, third-party guarantees to limit the size of exposures or the risk of loss. Clearing houses in some countries use the central bank as the sole settlement bank, which effectively eliminates the risk of settlement bank failure.
However, clearing houses in other countries use private settlement banks and, therefore, are exposed to the risks of settlement bank failures.
Such failures could pose both credit risks and liquidity risks to a clearing house. The size of the clearing house's credit and liquidity exposures to its settlement banks may be quite significant. However, whether this is so depends critically on: 1 the amounts owed to the clearing house by clearing members that utilised the settlement bank on the date of its failure; 2 the timing of the settlement bank's failure; and 3 the terms of the settlement agreement between the clearing house and its clearing members and settlement banks.
The amounts owed by clearing members in any particular money settlement at any one settlement bank depend primarily on the positions held by those clearing members and on changes in the market value of those positions In a particular settlement, a given clearing member may owe the clearing house money or may be owed money by the clearing house.
The amount owed to the clearing house, if any, by a single clearing member can vary quite considerably from day to day. As volatility increases, a CCP issues IM calls, because the likelihood of further large fluctuations in the price of the underlying asset also rises Graph 6 , right-hand panel.
In meeting IM calls at short notice, en masse, banks may face larger-than-normal haircuts on liquid assets a "fire sale" , or may even need to tap into their illiquid assets Graph 6 , left-hand panel. A feedback loop could then arise, as the banks' fire sales might spill over into the derivatives markets, especially if banks sell precisely those assets that were stressed in the first place.
The spillback could then exacerbate the very volatility that prompted the IM calls. A key characteristic of this scenario is that the CCP, fearing the depletion of its default fund, postpones margin collections from a stressed bank ie forbears. The Brexit referendum led to large margin fluctuations on 24 June The outcome surprised markets, causing sharp swings in exchange and interest rates and thereby triggering large intraday margin calls for banks in the interest rate swap markets.
Publicly available data on the size of these margin calls for individual banks are limited. While the Brexit event moved markets, it did not cause widespread turmoil or problems in specific financial institutions. It did, nonetheless, lead to large margin calls and liquidity outflows for banks. Such margin calls, if they were to happen in a more volatile environment, could subject banks to substantial liquidity strain.
The reason is that margins represent a relatively large proportion of banks' total high-quality liquid assets HQLA Graph B , right-hand panel. The estimated margins for individual G-SIBs range from 2. Under an adverse scenario, when liquidity is already likely to be under pressure from other sources and markets are experiencing fire sales, margin calls can represent a potentially serious source of liquidity risk.
More reassuringly, however, larger institutions tend to have lower margin-to-HQLA ratios, which would tend to limit the systemic ramifications of increased margining.
See CFTC In this scenario, one large clearing member bank cannot meet its VM calls due to the high market stress Graph 7 , red cells in the left-hand panel. Technically, it is in default. However, the default has to be officially acknowledged by the CCP if it wants to use any of the default waterfall funds. Additionally, the CCP could face reputational losses and impaired franchise value. The hope that the bank would be able to pay VM at a later stage incentivises the CCP to forbear recognition of the member default, to the extent possible crossed arrow in Graph 7.
The CCP's forbearance allows the stressed bank to continue its usual business activities. On the one hand, the CCP acts countercyclically and could potentially avoid destabilising the financial system. On the other hand, banks that are close to failure are tempted to gamble for resurrection eg Freixas et al For instance, CLAM's forbearance enabled the stressed member to pile up even larger positions, which amplified its initial losses see Bignon and Vuillemey The third scenario stems from extreme market stress that forces the CCP to declare the default of one or more large clearing member banks.
CCP failures are few and far between. These episodes have some elements in common. First, all three CCPs cleared long-dated derivatives contracts. Second, the weeks before the failure saw unusually high volatility in the underlying asset price. Third, unmet margin calls by the clearing members triggered the failure. There have also been a number of near-failures associated with periods of market stress IMF In the wake of the October equity market crash, both the Chicago Mercantile Exchange and the Options Clearing Corporation met with difficulties in receiving the required margin increases from their members.
In some cases, CCPs have come under stress in relatively benign market conditions. In December , a Korean CCP dipped into its mutualised default fund after one of its members - a small broker-dealer - defaulted because of a trading error. Together, these episodes highlight the fact that, while CCPs are designed for safety, they can fail. See the Davison Report for more details.
In this scenario, surviving member banks are asked to cover any losses remaining after the prefunded resources have been exhausted Graph 8 , right-hand panel. There are two main tools available to the CCP in this setting left-hand panel.
First, the CCP can issue cash calls, asking all surviving members to cover the remaining losses. In such extreme stress, however, the prudent individual behaviour of surviving members would be to hoard liquidity in order to safeguard their own stability Morris and Shin In other words, the surviving members can refuse to honour their cash calls dashed arrow on right-hand panel.
If they do so, this would deny resources to the CCP, threaten its recovery and, ultimately, destabilise the financial system as a whole. Even if surviving members do honour their commitments, some of them might have to resort to fire sales in order to access liquidity - thereby putting pressure on the broader derivatives markets and hence back on the CCP Holden et al In effect, this would allow the CCP to draw on any VM gains of the non-defaulted clearing members in order to cover losses solid red arrow on right-hand panel.
While VMGH eliminates the risk of non-performance by banks, it implies that certain derivative contracts will no longer hedge other risks that banks have taken on. This could threaten the viability of the non-defaulted banks. Either tool may place, or threaten to place, non-defaulted banks under stress. In turn, the stress on banks could put further pressure on the CCP.
Ultimately, in order to avoid a broader fallout that endangers the entire financial system, the authorities might have to step in to place the CCP in resolution Cunliffe In fact, regulatory standards for CCPs and banks are set up to work with one another and to reinforce incentives to ensure financial stability.
And agencies have considered various second-round effects eg ESMA However, given the complex web of incentives, spanning different institutions and markets, what might transpire under some stress scenarios is less than fully understood.
Arising from balance sheet interlinkages and the structure of the CCP default waterfall, these interactions can vary with the level of stress. Under some conditions, they might lead to a destabilising feedback loop with potentially system-wide effects. This puts a premium on the joint assessment of banks' and CCPs' risks in order to understand the endogenous build-up of risk.
Even though our framework is stylised, it could help frame policy discussions. Admittedly, we have abstracted from potentially important institutional details, such as the CCP ownership structure or linkages stemming from the provision of credit lines by clearing members. That said, the framework incorporates key institutional characteristics and allows for an intuitive explanation of the often complex interactions between banks and CCPs. Bignon, V and G Vuillemey : "The failure of a clearinghouse: empirical evidence", Review of Finance , forthcoming.
Duffie, D and H Zhu : "Does a central clearing counterparty reduce counterparty risk? Holden, H, M Houllier and D Murphy : "I want security: stylized facts about central counterparty collateral and its systemic context", Journal of Financial Market Infrastructures , vol 5, no 2, December.
Norman, P : The risk controllers - central counterparty clearing in globalised financial markets , Wiley, May. The views expressed in this article are those of the authors and do not necessarily reflect those of the BIS. This is done using the share of notional amounts outstanding that dealers report against CCPs solid lines in Graph 1 , left-hand panel and assumptions about the extent to which the reporting population includes the full set of participants. See Wooldridge and Aldasoro and Ehlers for details.
These issues are beyond the scope of this article. Subject to regulatory minimums, CCPs can differ in terms of the specific parameters or methodologies they use for setting margins.
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