feed

Article: Fed Official Slams ‘Fantasy’ Of CCP Default Management

23 October 2014 | Dee Dervish

http://www.risk.net/risk-magazine/news/2375933/fed-official-slams-fantasy-of-ccp-default-management

Having read this article on Risk.net (subscription required) I am not sure that securing the time of a handful of traders (usually five or six) from a membership of 70+ banks that have a trading presence in multiple locations globally should be described as a "fantasy". Traders from member banks that form the emergency committee referred to as the Default Management Group (DMG) or Committee (DMC) meet with the CCPs regularly to monitor the risk levels in current market conditions at the CCP and to work through enhancements to the Default Management Processes (DMP) including the default fund contribution and utilization. If the CCP is London based, then traders from London are often on the ‘rota’. Similarly if the CCP is North America or Scandinavia based, then local traders are usually on those rotas. I am not suggesting that having 15 CCPs in one location would allow the current model to work, but many of the 15 CCPs referred to in this article are based in the financial centre for which they were created to service. If for whatever reason the same trader is asked to represent a bank on multiple committees, then it is a “responsibility as a bank to make sure you don't have the same traders on two different CCPs at the same time”

If there should be any concern or criticism over the current DMP, then I believe the focus should be on the way in which the exercises are conducted which are designed to test both the members and the CCPs. These are often referred to as a Fire Drill.

Having worked very closely with the DMP for several CCPs from as far back as before the Lehman default and then with many more banks from a member perspective, I have seen how this process has been shaped by the efforts of many of these members and in particular one CCP that provides its members with comprehensive test data and full support. However, there is room within all of these processes for significant improvement globally – let me explain:

1- When the CCP holds conference call working group meetings with its member banks to solicit feedback on proposed Fire Drill dates, members often request that particular dates are avoided because ‘another’ CCP is going to be conducting a Fire Drill during that period. I would like to think that this would have been a perfect opportunity to test that the banks are capable of managing such a realistic scenario. I have been advocating a coordinated global Fire Drill since I worked on the default management process at SwapClear during the Lehman default. For one reason or another, despite many such calls from my colleagues in the clearing sphere, this has not yet come to pass.

2- Every time a CCP schedules a Fire Drill, they provide members with advanced notice of 3-6 months. I have worked with more than enough members to understand why this is– project teams are put together and trained, environments built or readied, trade import, pricing and reconciliation systems are tested- whereupon they realise the CCP has upgraded their FpML version or added new products or features and these systems and processes need further development to make then work to comply. If only a real default would provide the market with a similar advance notice, then all would be fine in the world…

3- Fire Drills are conducted by major CCPs every six months. Many banks are often members of two OTC CCPs, this means that there are four Fire Drill exercises each year. A typical member bank will require resources from IT, Trade Support and Front Office. Most member banks will schedule between three and six resources for the period of each Fire Drill which is planned to last (often two weeks) for as long as the slowest or least prepared member has demanded that the exercise needs to last by giving such feedback at each post event review requested by the CCP. If our friend from the Fed should be concerned, it should be because of the 250 “human capital” committing 2500 man days managing each simulated default event that everyone knew would happen 6 months earlier...

So what needs to change?
1. CCPs need to coordinate to conduct a Fire Drill on the same date. Their respective emergency committees need to work out how they might manage the offsetting risk between each portfolio should such an exposure exist.

2. CCPs need to work with members to significantly reduce the notice requirement for a Fire Drill exercise to something more akin to a real default situation.
For example:
a- If a bank were to be put into default at the weekend, the Default Management Committee would convene on the Monday - this is the first test of the Fire Drill and DMG members should be measured on this ability so that changes can be made ahead of an actual default.
b- Analysis and risk neutralisation of the portfolio occurs over the course of the next day or two – the effectiveness of which is often measured at the end of the exercise by how little margin has been eroded. This measure should also include how risk neutral the portfolio being auctioned is according to all the participating members.
c- By the time the hedged portfolios are ready to be distributed by the CCP, each member bank should be ready to begin their part in the DMP. So I am saying that CCPs and members need to reduce the notice from 6 months down to 2 days to make a Fire Drill a real test of what it is supposed to be testing– simple!!

The only thing that is being tested currently is the ability to consume auction files accurately and to reconcile, value and bid etc. which should be done as a regular internal exercise by each member as a matter of course. This can be achieved by using the test data that is regularly made available by the CCP which allows members to remain default ready at all times. The actual Fire Drill event should be as close to a real default simulation as possible, to test that members (and the CCP) can deploy the resource and systems in a default realistic timeframe and then demonstrate that it all works.

3. To allow members to manage all of the above, they need default management systems and processes that are incorporated into their BAU operations and systems which can be deployed and used in the time that would be available if a real default were to occur today. Many of our clients are able to do this now. Member banks that I have worked with recently can manage the entire member facing part of the DMP in less than 1 hour, unfortunately there are still many more members that have much work to do to reduce their current requirement from several days, to a more realistic timeframe.

Dee Dervish, Formicary.


Comments

Dee enjoyed your comments and agree with all you say.

The co-ordination of the fire drills between various CCPs to create a real life scenario is going to become an essential and it would not be a surprise if this became mandated. This should easily become BAU for the banks on a less timetabled and more reactionary simulation to create a more realistic version of the real world default. Lehman demonstrated that the concept works but the breadth and depth of clearing has increased exponentially since 2008.

The issue about the Default Management personnel from the banks providing the correct expertise to enable effective hedging and risk assessment seems to me to be the real crux of the FED's issue. During a crisis, members of the default management group are permanently assigned to the CCP for the duration. It was therefore very difficult when running a trading desk to assign the correct personnel to help unwind the CCP portfolio at exactly the time when you need the trading expertise internally to manage the house positions. This issue is massively compounded by the increase in the number of CCPs that clear OTC products.

That being said, under current OTC clearing it is relatively simple for the clearing member to provide one resource to hedge the cleared instruments as they are strongly related products which are habitually traded together at the institution. This becomes more complicated as the number of products cleared increases and the attraction of cross-margining of these products to the clearing members becomes essential to reduce clearing costs. The result of this imperative is greater complication in the default management portfolio that has to be hedged during a member liquidation.

The portfolio effect of diverse, but correlated, cleared products means that the unwind process has to become correspondingly more efficient to justify the reduction in risk margins posted at the CCP. This plethora of products in one trading basket will mean that the number of traders with expertise across all the basket of derivatives will be even more limited than it is now. As additional products clear and are cross-margined (Swaptions, Inflation, and Repo in a portfolio is entirely feasible soon) this situation will get worse and regulators will be looking at the rationale for the margin reduction very closely.

As with all things in the current environment the scrutiny will only get greater!