Clearing banks show they’ve learned lessons of the past

The spread of the coronavirus in March left a trail of loss in the financial markets, wiping out investors and bankrupting companies.   

But the markets can take some comfort in the fact that these losses did not spread to the biggest central counterparties (CCPs) that ultimately assume the default risk of funds and corporates that trade derivatives. Not one major CCP declared a default event over the first quarter. Not a single cent of their guaranty funds was tapped to cover losses from failed members.

This is all the more surprising considering the sheer amount of the initial margin (IM) needed to cover losses over the quarter. On one day, LCH’s SwapClear demanded £5.3 billion ($6.7 billion) from its 66 clearing members – £80 million from each, on average. In Q4 2019, the largest aggregate IM call was £1.5 billion, or about £23 million per firm. Chicago-based rival CME’s swaps clearing service disclosed a peak IM call of $3.3 billion across 16 members – $206 million apiece on average. 

Even this understates the size of specific IM calls individual members had to meet. At one point in Q1, a single account at SwapClear had a $558 million margin shortfall. Another at the Depository Trust & Clearing Corporation’s mortgage-backed security division had a whopping $1.5 billion deficit. Had the owners of these accounts not posted sufficient margin in time, their positions would have been liquidated, exposing the clearing houses to huge losses.

That clearing members were able to meet these mammoth margin calls speaks to the size and stability of their liquidity buffers. Most CCPs require IM to be posted in cash or sovereign bonds. At CME, cash IM increased nearly threefold over Q1, by $60.6 billion, while sovereign bond IM grew by $30.7 billion – about 30%. Clearing members had to deliver this at short notice to avoid a wave of defaults.

Perhaps clearing members have learned the lessons of previous crises. Following the result of the Brexit referendum on June 24, 2016, record-breaking moves in a number of markets resulted in huge intraday IM calls – some of which were in the billions of dollars. The episode revealed an uncomfortable truth: central clearing simply replaces counterparty risk with liquidity risk. The stability of the system relies on giant clearing members, which handle the bulk of cleared trades, always having enough liquid collateral on hand to satisfy margin calls – for their own account as well as for any clients that welch on their obligations.

This concentrates risks in a small number of players, and makes them vulnerable to sudden, unexpected shocks, such as the coronavirus crisis. Some clearing banks did see big losses – notably ABN Amro, which had to cover the default of Parplus Partners to the tune of €235 million ($266 million).

But no clearing bank was caught short by a supersized margin call.

CCPs may not be out of the woods yet. The markets are still fragile, and with vast amounts of cash and safe bonds already locked up in margin accounts and CCP default funds, it may be harder – and more expensive – for clearers to source liquidity if there is a second coronavirus-linked market collapse.