Ten (10) Tips to understand credit risk to Central Counterparties (CCPs)
First of all, what is the "waterfall" and the "skin in the game"?
CCPs take collateral from clearing members after calculating variation and initial margin. If on a given day, a client or a clearing member fails to post margin, the collateral posted on the previous day should be sufficient to cover any losses. However, if the CCP had collected insufficient variation margin to pay those clients with a position opposite to the defaulting client and / or if market prices move and the initial margin that had been posted by the defaulting party is not sufficient to cover the new exposure, then the CCP would have a shortage of collateral. EMIR (Article 43, No 3) suggests that if there is a shortage of collateral, the process to cover the losses follows an order or "waterfall" as follows:
- The CCP should tap first into the collateral provided by the defaulting client or clearing member (either provided as Initial Margin or Default Fund contribution)
- Then use the "skin in the game or SIG", which is the CCP's own money that is set aside to fund eventual shortage of margins if one of the members defaults.
- ...and then the money contributed by the clearing members to the default fund.
However, this order has not always been the case, and it looks like there is no regulatory requirement for at least some non-EMIR Central Counterparties (CCPs), as in Korea’s based HanMag’s case.
To avoid being caught by a surprise, clients and clearing members should make it a priority to analyse credit risk to CCPs.
10 tips to analyse credit risk aspects with Central Counterparties (CCPs):
- Check the CCP's credit rating (if any is available), or analyse their credit risk. As any other company they aim at making profits, have a capital structure and take risks as any business would.
- Can CCPs keep topping up the “skin in the game or SIG” if their business expands? (how is this amount calculated?)
- Who are the other clearing members or clients (if you are a member of a club, you would want to know who are the other members and how strict are the new membership policies). How likely is the clearing member defaulting on margins and / or running out of cash to top up the default fund?
- Does the CCP have stop losses rules or maximum position limits by clearing member or by client? If not, a client with a high concentration of activity may bring trouble if at one point it cannot provide margins, the impact on value could be worse if prices change significantly.
- Can the CCP cope operationally with calculating and calling for all the client’s/clearing members’ margins, timely and accurately? HanMag’s problem seems to stem from being short of collateral to cover a default, and finding itself under-margined due to an operational failure in its margin algorithm.
- Check for the CCP’s calculations transparency and your own ability to agree or dispute initial and variation margin. Make sure you are capable of challenging the value of the collateral posted, as opposed to relying on the CCP estimating this value timely and correctly. It is your cash and securities and you do not want to give more than you are obliged to.
- Does your clearing member pass on the risk over to you as a client, or is the clearing member a shield between the client and the CCP.
- As a client, check how your cash moves from when it takes off from your account, then travels through the clearing member and lands on to the CCP. Watch out for netting, haircuts, segregation, portability alternatives, inter-operability. What instrument, who has it, where is it kept, when does it move and how much are the questions you need to ask in relation to the cash you provide as collateral. See attached diagram.
- Default procedures how quickly can the CCP settle open positions upon default? What are their porting procedures? How often do they practise these procedures with members?
- Read the CCP’s and clearing member’s rules before you join…they are not just standard “small print”.
As we know, trading means taking risks. Clearing helps a lot in mitigating counteparty risk, but is not perfect.