Since the default of power trader Einar Aas on Nasdaq Commodities last September, a radical idea has been gaining ground among some clearing banks: that some futures products are simply not fit for clearing.
It sounds like an extreme reaction, but for some, the difficulties Nasdaq encountered in managing Aas’s default have shone a bright light on the clearing of some futures products, and one asset class in particular: commodity derivatives.
The global commodities markets are no stranger to violent blow-ups. By their nature, commodities are governed by seasonality, and prone to sudden, sustained spikes. These markets often feature a small cadre of dedicated players, with banks and institutional investors dipping in and out as returns dictate, which makes gauging liquidity difficult.
Now, clearing houses are being asked to review the margining and risk management of products where trading is dominated by only a few large, sophisticated users capable of taking on one another’s portfolios in a default.
Nasdaq faced sharp criticism for its decision to invite only four firms to the auction, which had to be re-run – something clearing members argue resulted in uncompetitive bids, and the crystallising of a loss that they had to mop up.
The clearing house’s defence – that it only invited a select group of participants it thought able to bid on the portfolio’s risk at auction – gets to the heart of the problem banks have with clearing less liquid commodity contracts.
As a best practice paper from the International Swaps and Derivatives Association published in the aftermath of the default puts it: “For a product to be suitable for clearing… there needs to be a suitable number of members that clear the product and commit to participating in its default management.”
Clearing houses should have “the discretion to discontinue clearing products” that fail to meet that standard, the paper adds.
To be sure, the German and Nordic power futures Aas was trading were not inherently complex. The risk for would-be bidders lay in the size and concentration of the portfolio. Aas is said to have held half the open interest in the spread position he was trading, with the margin obligations on his portfolio alone estimated at €60 million.
Nasdaq’s failure to hedge the portfolio before putting it up for auction has also drawn criticism. Its defence for not doing so before the failed first auction – that the market was too illiquid for it to step into without moving prices significantly – gets short shrift.
Two CCP risk managers at global banks tell Risk.net that this amounts to Nasdaq admitting it cannot risk manage the products in question – and that, if it cannot risk manage them, it should not be clearing them.