The key to clearing is balance. If every long position is matched with a short position, every fixed-rate payer with a receiver, then the job of a clearing house is simple – it collects margin from one side and pays to the other, keeps its buffers topped up, and trundles along merrily.
The problems start when a default happens. Suddenly, the clearing house is unbalanced – margin is not being collected on some of its trades – and the fate of every participant depends on being able to regain equilibrium.
This year, the world’s biggest credit derivatives clearer – Ice Clear Credit (ICC) – has tried to give its members and their clients better answers on how it will perform this high-wire act, and the role each of them will play. Some of those answers are currently unique, the culmination of a four-year review of its rules, but Stan Ivanov, the clearer’s president, predicts they will become a blueprint for others.
An executive at one large member firm agrees, describing Ice Clear Credit as “the gold standard in terms of thoughtfulness on process and risk management”.
Arguably the most eye-catching innovation is the ability for non-members to take part in the auction that is supposed to return a central counterparty (CCP) to a matched book.
In the normal course of things, a CCP responds to a default by slapping a rough hedge on the open positions and then trying to auction off the portfolio belonging to the defaulted party. In the Lehman Brothers default, this was successful – but not without some games being played. Bidding was restricted to SwapClear’s member banks, many of which were also under pressure. Bidding from some firms, on some portfolios, is said to have been wildly off-market – an attempt to ensure they did not have to shoulder additional margin and capital burdens.
Bringing non-members into the auction ought to create a more diverse group of bidders. To mitigate concerns that casual bidders might seek to abuse information obtained during the auction process – potentially front-running other participants – non-members must pledge $10 million to the CCP’s guarantee fund as the cost of entry. They would only receive their pledged amount back if their bids are competitive.
A chief operating officer at one large hedge fund applauds the move: “This has been great. We are planning on participating before the end of the year in a test exercise of a clearing member defaulting. It’s a huge move forward to be able to include non-clearing members in the auction process.”
It was more appropriate to shift the balance between collateralisation versus mutualisation to decrease the probability of loss mutualisation for losses due to client-related portfolio lossesStan Ivanov, left, with Peter Borstelmann
In the event of an auction failing, one of the last resorts for a CCP would be to share out the defaulted party’s positions among the survivors – a step known as forced allocation. This is a popular tool with some regulators, who argue the dangers of being stuck with an unknown portfolio during a market meltdown would increase the chances of members bidding responsibly during an auction. But members argue it could create contagion. At ICC, the latter argument won the day – forced allocation has been ditched as an option.
In its place is a tool known as partial tear-up – the voiding of unmatched positions. This has the side-effect of leaving parties to those trades abruptly unhedged, potentially causing a flurry of re-hedging in stressed markets, but it was judged to be the less-risky solution.
Also up for grabs was the option of haircutting variation margin (VM) and initial margin (IM) – a tool that could be used to cover spillover CCP losses earlier in the process, but would ultimately not restore a matched book. Each option would hit a different group of clearing participants. By definition, VM can only be cut for firms with winning positions – a policy that might encourage gaming by firms if a default was on the cards. In contrast, every firm contributes IM, but cutting this would mutualise a defaulted firm’s loss across all participants.
These discussions are said by Ice Clear Credit to have been “dynamic”. A range of possibilities were explored: different periods of reduced gains distributions; the position of the reduced gains distributions in the default management waterfall; whether it would be legally possible to haircut gains in the context of rules requiring finality of settlement; and ultimately whether the tool would work – whether it would help a CCP to continue operating.
They took on board our feedback and made changes to guarantee fund calculations across its book of clients, bringing contributions down 20%. I’m not sure any other clearing house would have listened in that way and turned it around in a few months with the speed that Ice didClearing member
While industry participants were divided on the details, agreement emerged that IM haircutting should not be used in a CCP’s default management process. Variation margin is still an available tool, but has been moved to the back of the waterfall.
Ice Clear Credit is so confident none of this will be required that it has pushed its own capital closer to the danger zone. Ordinarily, a CCP will cover losses in a default by first using up the defaulting firm’s initial margin and guarantee fund contribution, then the contributions of non-defaulting members, before its capital is touched. Under ICC’s new structure, its capital would be consumed prior to the guarantee fund contributions of non-defaulters.
The changes continue, reaching into the calibration of the default fund, and the legally segregated, operationally commingled account structures used by clearing clients in the US.
Like other over-the-counter derivatives CCPs, ICC has gradually shifted from being a venue for interdealer clearing – in which members were expected to mutualise their risk – to one in which much of the risk is being brought into the venue by clients. Members complained – too much client risk was being covered via the guarantee fund – and Ice’s Ivanov says there was some truth to that.
“It was more appropriate to shift the balance between collateralisation versus mutualisation to decrease the probability of loss mutualisation for losses due to client-related portfolio losses,” he says.
The CCP responded by tying guarantee fund requirements more dynamically to the initial margin levels generated by clients, and to client stressed losses.
One member at least is delighted with the outcome: “They took on board our feedback and made changes to guarantee fund calculations across its book of clients, bringing contributions down 20%. I’m not sure any other clearing house would have listened in that way and turned it around in a few months with the speed that Ice did.”
This is important stuff – and it’s complicated. Every change made to a CCP’s default waterfall creates winners and losers. Some have to shoulder more of the cost and more of the risk; others have to take less. Participants in the review say Ice Clear Credit managed this process well, seeking input from members, their clients and regulators, and trying to build consensus by carefully exploring a range of possibilities.
The member says: “Forced allocation is something we as dealers are very uncomfortable with. Being able to have a finite amount of risk as opposed to potentially being assigned contracts in a default scenario that we can’t value has always been a key area of focus. It’s nice Ice Clear Credit is implementing the changes we’ve been asking for.”
A second clearing member says: “The new recovery and resolution rules are cleaner. They clear up some questions and make the process more manageable. Ice Clear Credit are responsive and there is a pretty healthy feedback loop we have with them as a service provider.”
In the meantime, business was ticking over nicely. This year, ICC has seen continued growth in client single-name credit default swap (CDS) clearing; 2017 notional currently stands at $350 billion compared with $190 billion in 2016. It has also launched financial single-name CDS clearing and seen strong growth in both index and sovereign activity. It is the only clearing house to support emerging market CDX and Latin American and Asia-Pacific sovereigns and corporates.
In mid-September, rival CME announced it would exit the CDS clearing business by mid-2018 to focus on OTC clearing services for interest rate swaps and foreign exchange. Ice Clear Credit is now working with CME, anticipating its full book will transition over in the first quarter of 2018 either via natural trading or a bulk position port of any remaining positions.
On September 20, Ice underlined its pre-eminence in the cleared CDS market, declaring a daily record of more than $450 billion cleared, together with a record monthly gross notional value of $1.75 trillion.
ICC is now working with CME, anticipating its full book will transition over by Q1 2018 either via natural trading or a bulk position port of any remaining positions.
The clearing of CDS index options is in train – Ice Clear Credit will first start valuing options and delta hedges in real-time, in anticipation of a launch that could come as early as the fourth quarter of 2018.
One cloud is the danger that the European Union could require euro-denominated derivatives to be cleared within the eurozone – although the impact would be more significant to Ice Clear Europe, which clears larger volumes of euro-denominated instruments than Ice Clear Credit. Alternatively, the EU could insist that systemically important foreign CCPs are subject to tougher oversight.
Ivanov plays a straight bat: “It is premature to discuss the market impact as we have to see the actual approach.”