A tale of two CCPs

Clearing houses are designed to manage the derivatives market’s systemic counterparty risks, by centralising them, collecting margin and applying rules for the orderly sharing of losses. In theory, when a default hits, the pain is kept within the thick walls of the central counterparty, rather than spilling out into the wider markets.

Two recent episodes have shed some light on how this works in practice. Last September, Nasdaq Commodities consumed €114 million ($131 million) to plug the default of a single trader, Einar Aas. Of that total, €7 million was a slice of the CCP’s own capital, and the rest came from its default fund – last-ditch reserves contributed by each member.

Fresh insights on the episode can be found in recent public disclosures. These reveal that in the third quarter, Nasdaq Commodities incurred a peak margin breach which, at €23 million, was over seven times larger than any previously reported. It’s likely this was the breach that Aas was unable to cover and which cost Nasdaq and its members so much.

Yet Nasdaq wasn’t the only clearing house to report an outsized breach that quarter. Ice Clear Europe’s futures and options service incurred a whopping $1.2 billion peak breach of its own, nearly 20 times larger than anything on record prior.

The reason you may not have heard about the latter is that this breach did not lead to a default, as the unidentified member was able to meet Ice’s margin call, averting a potential disaster.

Little is known about this event, but Risk Quantum has it on good authority that the breach – which came from a single member account – arose from the trading of carbon futures. The member may have been a single firm trading for itself, but the sheer size of the breach implies it was instead a group of clients with directional positions, who were clearing via that member.

In both cases, the clearing system worked as intended. Nasdaq closed out Aas’s positions, replenished its default fund and cleared positions during and after the crisis without interruption. Ice hiked its mystery member’s margin requirement as exposures snowballed, protecting its – and its members’ – capital in the process.

Viewed another way, however, the twin episodes are less reassuring. Nasdaq’s default fund is supposed to be able to withstand the collapse of its two largest members, but Aas was no whale, and he still nearly took the ship down with him – perhaps because the large, illiquid positions proved difficult to auction off. The defaulted portfolio itself represented less than 5% of the total initial margin pool for the commodity clearing service. Had it been larger, the default fund could have been depleted entirely.

Over at Ice, the member appears to have been carrying enough cash to top up its margin – hopefully, the CCP itself was confident that would be the case. But what if there had been a shortfall? Then, Ice would have faced the challenge of closing out a huge, directional portfolio at a time when many of its members were grappling with their own spiralling market exposures, as evidenced by the number of breaches reported at the clearing house in the third quarter.

Ultimately, both central counterparties weathered their respective storms, but the two episodes are a reminder of the huge risks CCPs can run, even in smaller markets.