Putting risk mitigation centre stage
Written by Michael Davie
Michael Davie sheds some light on the role clearing houses play in the risk management process
The recent financial crisis has turned the attention of regulators and policymakers globally to the vital role that clearing houses play in mitigating risk. Whilst it is an interesting time for the industry, it is important that the limitations of clearing, alongside the benefits, be understood.
Clearing houses mitigate risk in two key ways. Firstly, by addressing counterparty risk. Simply put, after clearing, the exposure of two trading market participants is to the clearing house. Bilateral exposures are consolidated into a single low risk exposure to the central counterparty (CCP).
CCPs also reduce risk through multi-lateral netting as the clearing house is able to net down the trades’ exposures, thereby reducing overall exposure, in some instances significantly. For example, in the last 12 years, LCH.Clearnet has cleared and netted OTC fixed income trades with a settlement value of circa
€1.6 quadrillion, thereby reducing settlement obligations by circa €800 trillion, significantly reducing systemic and settlement risk in the European fixed income markets.
During normal market conditions, these are unlikely to be the primary drivers for clearing. However, at times of market uncertainty, when counterparty risk becomes a concern for trading institutions, these benefits can be marked.
Exchange traded vs OTC
The underlying aim of clearing is to protect market participants in the event of a default. To appreciate the challenges of managing an OTC default, it is important to understand the differences in the way that listed derivatives and OTC derivatives are traded. Exchange traded contracts are standardised, listed, generally liquid and traded in an established market place. Even at the point of a major bank default when markets are likely to be highly volatile and liquidity scarce, there is a venue to which the clearing house can turn in order to hedge or dispose of its risk.
At LCH.Clearnet we have success-fully been clearing OTC derivatives since 1999 and are the only clearing house to have managed a significant OTC default. Clearing OTC derivatives is not impossibly complex, but the characteristics of the transactions have important implications when managing the risk. It is very different to clearing listed derivatives.
The bespoke nature of OTC derivative contracts results in a lack of fungibility, making it difficult for traders to close out positions. Furthermore, the contracts often have long maturities, with counterparties exposed to each other for the entire duration until the transaction expires. At the time of default, the clearing house will be left holding many OTC trades – in the case of the Lehman Brothers’ default we inherited 66,000 in five currencies – as well as significant market risk. These are neither liquid nor easily disposed of and it is therefore imperative that any OTC clearing house has a detailed default management process in place which will enable it to safely manage this process.
This process consists of two key phases, the first, managing the market risk. For this, clearing houses need access to accurate pricing information, without which the most sophisticated algorithms are useless. These must be prices at which people will trade, even in the most volatile times, if the clearing house is to hedge market risk.
The second is disposing of the defaulter's portfolio which cannot simply be traded via an exchange. At LCH.Clearnet, we rely on the service of members who are obliged, by the terms of their membership, to bid for the defaulter’s portfolio. They also undertake to work with us during a default and provide us with the data and expertise we require – no light commitment on their part. They agree, under legally binding contracts, to give us the information and expertise we need to manage the default. They recognise that the operational and capital benefits of OTC clearing come at a cost: the mutualisation of responsibility should one of their number fail.
The close involvement and commitment of the dealers in the default management process is crucial. At present, they give us the access to markets, prices and expertise required to manage a default, and they are obligated to absorb the defaulter’s portfolio in the event that it cannot be successfully auctioned.
Adopting the highest possible risk management and margin standards
This mutualisation on behalf of the dealers should underpin already robust risk management systems. Prudent risk management, appropriate margining, adequate membership criteria and thorough back-testing are all essential.
Without robust risk and default management procedures, there is a real danger that the risk is simply transferred. As competition for clearing increases, clearing houses must avoid the desire to compete on margin (i.e. a race to the bottom).
To survive the stresses and the default of a large clearing member, LCH.Clearnet charges margin to cover a five-day move in interest rate swaps, based upon the maximum loss over the past five years of historical data. For client positions, LCH.Clearnet also incorporates a 48 hour window to accommodate portability.
Additionally, LCH.Clearnet conducts stress tests using substantial historical scenarios that may have occurred outside of the previous five years.
The future of OTC clearing
OTC clearing has been operating successfully for many years, but as the new regulatory landscape takes shape, the market is likely to be significantly affected. Trades that are considered standardised and eligible for clearing are
likely to be those liquid enough to be priced on a daily basis, so there is an expectation of the types of products likely to move to mandatory clearing.
In the new regulatory environment, which aims to reduce systemic risk, it is imperative that the enthusiasm for more OTC clearing is combined with a real appreciation of the importance of a robust default management process. We believe it to be necessary if OTC clearing houses are to survive the next major default and really contribute to a reduction in systemic risk.
Michael Davie, CEO, SwapClear at LCH.Clearnet