CCP default risks not correlated, CFTC finds

Timothy Massad: stress tests reveal “quite a bit of diversification” in CCP exposures

Timothy Massad, CFTC chairman: CCPs easily passed the CFTC's stress tests

The failure of one clearing house is unlikely to have a contagion effect that brings down other central counterparties (CCPs), claims the top US derivatives regulator after releasing the results of new stress tests.

"Many people will assume that if one clearing member has trouble, all of them will. And [the stress tests] found quite a bit of diversification," said Commodity Futures Trading Commission (CFTC) chairman Timothy Massad. "No single clearing member had the largest loss in more than six of the 36 tests and no two firms generated the largest losses at more than one guarantee fund in any scenario."

Massad was speaking at a press conference to announce the results of a series of CCP stress tests administered by the CFTC earlier this year.

The tests assessed whether the five largest derivatives CCPs – CME Clearing, Ice Clear Credit, Ice Clear Europe, Ice Clear US and LCH – would be able to survive the default of their two largest clearing members, known as the cover two standard.

As part of the testing, the CFTC looked at how the positions of the 15 largest clearing members at each CCP would be affected in a series of 11 'extreme but plausible' scenarios.

Given the commonality of membership across various CCPs, this resulted in 23 member firms being evaluated using historical position data as of April 29.

"If you look at our 11 scenarios and you say let's look at who had the largest losses, what are the two firms? Those two firms were not the same at more than one guarantee fund," Massad said.

The clearing houses achieved cover two – in other words, the required resiliency standard. In every single instance, 100%
Timothy Massad, CFTC

The five CCPs easily passed the stress tests, meaning they held sufficient margin and pre-funded default resources to cover losses under each of the scenarios.

"The clearing houses achieved cover two – in other words, the required resiliency standard. In every single instance, 100%, and we found these pre-funded resources allowed them to exceed that cover two standard," Massad said.

The CFTC's stress tests included scenarios where a range of futures contracts see simultaneous price drops of up to 20% compared with the previous day, or where credit-default swap spreads widen by as much as 60 basis points.

"Clearing houses had the financial resources to withstand extreme market price changes across a wide range of products," Massad said. "The cover two requirement was met in every single test and in 64% of the tests – again, 64% of the unique scenarios – there was sufficient coverage to cover a default by every single clearing member, assuming again no clearing member posts any additional margin."

The European Securities and Markets Authority's (Esma) stress tests, which covered 17 European CCPs, found that while historical and hypothetical stress scenarios showed the CCPs met the cover two standard, more severe scenarios, such as the top two clearing members defaulting across all CCPs of which they were a member, produced uncovered losses.

The results of Esma's CCP stress tests were published on April 29. 

The CFTC's stress tests are significant because they use real positions from the day in question, and offer empirical evidence for how CCPs and member firms would be affected in those scenarios, which is generally unavailable even to clearing members.

Quarterly quantitative disclosures have been made by CCPs in line with requirements from the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (Iosco), which includes stress testing, but these disclosures are not entirely reliable.

For instance, the peak loss that would have been suffered by a CCP following the default of its two largest members would, in some circumstances, have exceeded its pre-funded resources, according to the CPMI-Iosco data. 

However, the peak day is taken over a 12-month time horizon, while the amount in the default fund is drawn from the last day of the quarter, making an equitable comparison difficult.

The CFTC's stress tests assume no extra money is put in by clearing members to support the clearing house. They also only cover the credit risk at the CCPs and do not factor in other risks to CCPs, such as investment or operational losses, which are regarded in some quarters as being a greater threat than member defaults, due to the CCP's inability to use pre-funded resources to support itself.

Ongoing work

Market participants have also argued that while credit stress tests are useful, they should be coupled with liquidity stress tests, which can be triggered by credit shocks.

One New York-based clearing head at a major US bank says that while the firm is "happy with the progress" on such tests, "there still needs to be a lot more work on liquidity stress testing".

Massad acknowledged the limitations of the tests in a question-and-answer session following the press conference, saying that while the regulator was pleased with the results, it was "not taking any victory laps over this".

"The key to clearing house resiliency is ongoing vigilance. There's a lot of other work going on that we are engaged in to make sure clearing houses are safe," he said. "A lot of work going on with domestic and international regulators. Constant risk surveillance by both the clearing house and us is critical. And, as I say, there's other categories of risks that we aren't even testing here."

A spokesperson for CME Group said it is "pleased both that the review went beyond a one-size-fits-all stress test to examine the multi-layered nature of derivatives risk management and that the results demonstrate the robust standards and strength of clearing houses across the industry".

LCH did not respond to a request for comment, while the Intercontinental Exchange Group could not comment in time.