Risks faced by CCPs: Risks caused by CCPs

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After completing this reading, you should be able to:

• Identify and explain the types of risks faced by CCPs.
• Identify and distinguish between the risks to clearing members as well as non-members.
• Identify and evaluate lessons learned from prior CCP failures

Types of Risks Faced by CCPs

Default risk

A clearing member may default on one or more transactions. Following a default event, a host of other problems may come up. These include:

• Default or increased distress of other members because of high default correlation
• Failed auctions, leaving the CCP with no choice but to impose losses on members
• Resignations because initial margins and default funds have to be returned to resigning members, the loss could be felt by other members.
• A worsening reputation – a default event would also injure the reputation of other members with close ties to fallen members.

Non-default events

Such events include:

• Internal/external fraud
• Operational losses
• Investment losses
• Losses due to litigation

Note that that non-default and default losses may be correlated. The default of a member might cause market disturbance and increase the likelihood of operational or legal problems.

Model risk

CCPs are exposed to model risk because of the use of a range of margining methods. Of note is the fact that there isn’t a reliable, dependable platform on which OTC derivatives can be observed. Valuation models may use subjective assumptions.

Liquidity risk

A CCP faces liquidity risk due to the large cash flows frequently transacted. In addition, the CCP must also choose its investments wisely so that it does not inadvertently create a shortage of cash necessary for day-to-day running.

Operational and legal risk

Centralization of various functions fosters efficiency, but on the downside, it creates a fertile ground for operational bottlenecks. For example, the CCP may have to contend with frequent system failures due to heavy traffic. What’s more, segregation and the movement of margin and positions through a CCP is prone to legal risk, depending on jurisdiction.

Other risks include custody risk in case of failure of a custodian, wrong-way risk, foreign exchange risk, concentration risk, and sovereign risk.

Risks to Clearing Members and Non-members

Risks to members:

There are several ways through which a clearing member can experience CCP-related losses:

• Forced allocation
• CCP failure
• Auction costs
• Default fund utilization
• Rights of assessment
• Tear-up

Prior to gaining membership, there are several mechanisms through which a prospective member can assess the risks faced by a member of the CCP. Such mechanisms may involve scrutinizing:

• The membership criteria
• Investment policies
• Default management policies
• Operational capacity
• Capital requirements
• The number of alternative CCPs and their credit ratings
• Initial margin and default fund contributions

Risks to Non-Clearing members:

Non-clearing members who clear indirectly through a CCP are usually faced with different risks, most of which may closely resemble those of clearing members. However, non-clearing members may have an additional layer of protection:

• If a clearing member defaults, clients may be safe provided their clearing member is in compliance with the CCP’s requirements and in good financial health.
• If a clearing member defaults, the CCP may safeguard the interests of non-clearing members through margin segregation and portability.
• Since non-clearing members do not contribute toward the default fund, their exposure to the CCP is indirect.

Lessons Learned from Prior CCP failures

In the last four decades, we’ve had several high-profile CCP failures and near-failures. Common sources of these failures include:

• Insufficient margins and default funds
• Large movements in the price of the underlying
• The failure to update initial margin requirements to reflect changing market conditions
• Operational problems associated with large price moves and system-crushing trade volumes
• Liquidity strains

Some of the lessons we can learn from these past failures include:

• Operational risk must be mitigated at all costs. Failure to act is never an option
• Variation margins should be recalculated frequently
• CCPs should have access to external sources of liquidity. They can easily default, not because they are insolvent but simply because they are illiquid in the short-term.
• CCPs should endeavor to monitor positions continuously and act quickly whenever there are large moves

Question

Which of the following is most likely associated with non-default losses?

1. Failed auctions
2. A worsening reputation
3. Internal/external fraud
4. Resignations

The correct answer is C.

A clearing member may default on one or more transactions. Following a default event, a host of other problems may come up. These include:

• Default or increased distress of other members because of high default correlation
• Failed auctions, leaving the CCP with no choice but to impose losses on members
• Resignations because initial margins and default funds have to be returned to resigning members, the loss could be felt by other members.
• A worsening reputation – a default event would also injure the reputation of other members with close ties to fallen members.

Internal/external fraud is in the category of non-default events. However, non-default and default losses may often be correlated.