Central counterparties in crisis: International Commodities Clearing House, New Zealand Futures and Options Exchange and the Stephen Francis Affair

Robert T. Cox, David Murphy and Edwin Budding

Abstract

ABSTRACT

The New Zealand Futures and Options Exchange suffered a clearing crisis in its
benchmark government bond futures contract in November 1989 after Stephen Francis, the holder of a large short position, defaulted. This paper examines how such a large position was accumulated, and how the default was managed. The roles of Francis's clearing members; the Exchange; the relevant central counterparty (CCP), the International Commodities Clearing House (ICCH); and the authorities are discussed. ICCH managed its exposure by invoicing back Francis's position, closing out opposing contracts at a price below prevailing market levels. In modern terminology, this was a "partial tear-up". It prevented losses from overwhelming the clearing house, but only by moving some of the financial burden to market participants. This paper shows how the allocation of losses depends on the invoice price, and compares the chosen default management strategy with other approaches. A key issue highlighted is the vulnerability of CCPs to large positions, which may be difficult or impossible to close out. Advances in clearing risk management and regulation that reduce the likelihood of this stress are set out. This paper concludes by suggesting that CCPs and their supervisors should plan for and be alert to this risk