Margin or membership? Regulators react to Nasdaq default

Six supervisors – from Bafin to the MAS – downplay idea of mandatory increase in futures MPOR

  • Market participants have suggested several ways to avoid a repeat of the Einar Aas default on the Nasdaq Swedish power market, including a longer margin period of risk and tighter membership requirements.
  • Regulators are reluctant to suggest there is a silver bullet and want CCPs to be more vigilant about all their risk management practices.
  • German regulator Bafin believes membership criteria carry the primary blame for the Nasdaq failure, while Sweden points to the auction process used to manage a member default.
  • The Australian regulator moved to increase MPOR for electricity markets in 2017, and several regulators suggest CCPs will need to respond more dynamically to changes in liquidity conditions in specific products while stopping short of advocating mandatory increases.
  • There is little appetite to revise the global principles for financial market infrastructures, with European regulators focused on making sure the existing guidelines are properly implemented through local legislation.

Global clearing houses are regulated by a college of supervisors drawn from across the countries where the central counterparty’s (CCP) clients are based. So when a CCP is forced to draw down heavily from its members’ default fund after losses suffered by a single private trader, supervisors are likely to have something to say about it.

In September 2018, Nasdaq Clearing members were left nursing losses of €107 million ($122 million) when an independent commodity trader clearing his own account at the Swedish operations of the CCP saw his bet that the spread between Nordic and German electricity futures would narrow blow up in his face.

Leaders at rival exchanges have already questioned the membership criteria and level of scrutiny that Nasdaq applied to monitor Einar Aas, the direct clearing member who caused the losses. Now, national regulators are asking the same questions.

Of course, market participants are more than happy to give their views on what regulators ought to do.

In the aftermath of the Nasdaq debacle, firms operating in the industry advanced a raft of theories suggesting how such a default could be avoided in the future. As well as improved auction processes, they cite deficiencies in margin methodologies, fresh examination of skin-in-the-game at CCPs, and the need to avoid commingling default funds for exchange-traded derivatives (ETDs) concentrated in small markets that are more prone to volatility alongside default funds for more liquid products.

However, the consensus among national regulators canvassed by following the Nasdaq default is that, having reviewed the clearing houses they oversee, no overarching changes to existing rules such as closeout periods for margin need to be imposed by supervisors. Instead, they want CCPs to consider a wide range of factors when assessing the risk posed by a clearing member.

The specific rules for clearing membership of a CCP were essential for the Nasdaq incident. It was therefore not a structural CCP problem
A Bafin spokesman

While acknowledging that investigation of the case continues, the findings so far have led German financial supervisor Bafin to believe that membership criteria were the primary cause of the failure at Nasdaq.

A Bafin spokesman says: “The specific rules for clearing membership of a CCP were essential for the Nasdaq incident. It was therefore not a structural CCP problem.” The regulator says that based on the information known in the case, it has reviewed CCPs under its jurisdiction “to rule out comparable incidents”.

Some in the industry think the Einar Aas loss was an accident waiting to happen and could have affected any clearing house, because margin methodologies lag changes in market structure. Even before the events at Nasdaq, there were 13 significant initial margin breaches in listed derivatives markets in the six months leading up to September 2018. Yet in cleared over-the-counter contracts there were none during that period.

Nick Rustad
Nick Rustad

JP Morgan’s head of clearing, Nick Rustad, has argued that automated trading is creating sudden spikes in volatility and the closeout periods for listed derivatives should be reconsidered. Initial margin for listed derivatives is typically calculated over a closeout period of between one and three days, compared with a minimum of five days for banks’ house accounts and up to seven days for clients for OTC contracts.

Assuming a longer period of risk would push up margin requirements. While Rustad stops short of saying clients should post more initial margin to help reduce margin breaches, he has highlighted a disparity between how CCPs calculate OTC and listed derivatives margin policy; a two-year note cleared at the CME holds 20% less margin than the equivalent OTC contract at LCH.Clearnet, for example.

But Bafin has come to the conclusion that an extension of the closeout period for listed derivatives “in the end does not prevent margin breaks. In the case of margin breaches, the cause should be investigated on a case-by-case basis. In particular, the margin model of the CCP and its calibration should be examined to determine whether any adjustments are necessary.”

Similarly, Japan’s Financial Services Agency (JFSA) thinks that – rather than focusing on close-out periods – additional margin should be collected from clearing members considered to have illiquid or concentrated positions.

A JFSA spokesman says: “Such additional margin could protect a CCP against a scenario where it may not be able to liquidate the positions of a defaulting clearing member in one day.” The agency says it has discussed the Nasdaq default with its regulated CCPs but declines to disclose further details.

In the jurisdiction in which the Nasdaq default took place, a spokesman for Sweden’s financial supervisory authority, Finansinspektionen (FI), says adjusting the margin period of risk (MPOR) for listed derivatives is “an interesting question, which is relevant to think about. However, it is too soon to make any conclusions.”

The FI says it is instead minded to consider the impact of price volatility during default management auctions due to changes in liquidity and risk appetite, as well as the number of active participants in a market. This is reflected in a FI paper published in January that spotlights CCP default management auctions.

No silver bullet

Other national regulators tell they have engaged with the clearing community to understand what lessons can be learned from the Nasdaq incident.

A market infrastructure supervisor at another major European prudential regulator, who declined to speak on the record, says in relation to MPOR: “What is really important is that CCPs and their members look at each market individually, and assess the right period of risk for that particular market. Closeout periods should be calibrated not only according to rigorous backtesting but also using forward-looking hypothetical scenarios.”

In their guidance, the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (Iosco) urge CCPs to stress-test “a spectrum of forward-looking stress scenarios in a variety of extreme, but plausible market conditions”.

The prudential supervisor emphasises CCPs should “keep the markets they clear under review, expanding closeout periods where it’s appropriate to do so, but also be prepared to adjust any part of their default waterfall or processes as situations evolve, whether that is around membership criteria, margin policies, offsets allowed for correlated products or auction processes. There is a need to look at all of those in the round and not assume that what works in one market applies in another.”

This holistic approach is shared by the Monetary Authority of Singapore (MAS). A spokesman says the regulator reviews international developments “to take into account lessons learnt from the experiences of international CCPs”. But he believes the assessment of whether changes should be made to specific risk management tools depends on several factors and may only be appropriate for individual products rather than across the board.

On the question of whether closeout periods should be raised, the MAS spokesman suggests this depends on the product in question and whether the market for it is liquid; when there are margin breaches, CCPs need to examine them to determine whether any follow-up action is required.

The International Swaps and Derivatives Association has also considered whether CCPs should consider more “dynamic” factors such as market liquidity, open interest, position size, concentration and number of active market participants when setting MPOR.

In a set of best practices published in January, Isda says: “Such an approach might increase the MPOR for some ETDs above the regulatory minimum, as is already best practice at many CCPs.”


In a prescient move, one regulator recommended in September 2017 that a clearing house it oversees should review its framework for MPOR assumptions. In its latest assessment of the Australian Stock Exchange’s facilities in September 2018, the Reserve Bank of Australia notes the ASX has increased the MPOR for all Australian dollar energy derivatives contracts, including electricity futures, from two to three days.

The change recognises that these markets are less liquid than previously implied, because they are dominated by end-users taking large positions relative to average daily trading volumes for hedging purposes. This makes it likely that closeout periods in a default scenario will be longer than for other products.

ASX has also adjusted its margin methodology to better reflect the potential for extreme price movements in these products, and increased the historical sample period from one to five years for ETDs. Further, it has investigated default management mechanisms for electricity derivatives that involve end-users in the market, the enhanced segregation of accounts and backup clearing arrangements.

Do PFMIs need updating?

None of the regulators spoken to by called for an immediate review of the global PFMIs – a set of guidelines issued by international regulators that assist financial market infrastructures in setting their rules – instead pointing out that they are subject to a regular review process anyway.

Yet, Bafin and the MAS say specific lessons from the Nasdaq experience could be useful for revisiting the PFMIs when they are reviewed.

A spokesman for Bafin says: “An update of the PFMIs seems to be too early at this stage. However, an update should be considered if such amendments can contribute to the prevention of corresponding failures, taking also into account the current Nasdaq incident.”

Since publication of this story, however, CPMI-Iosco is believed to be working on a joint discussion paper on the subject. The JFSA tells Risk it is “actively participating in such discussions.” Published in 2012 by the Committee on Payment and Settlement Systems (now CPMI) and Iosco, the PFMIs are not overly prescriptive in relation to MPOR, for example. They expect a CCP to “base its determination of the closeout periods for its initial margin model upon historical price and liquidity data, as well as reasonably foreseeable events in a default scenario”.

The PFMIs inform implementation of more detailed rules at a local level – in the European Union it is through the European Market Infrastructure Regulation, for example. Article 26 of Emir states that “these liquidation periods shall be at least: five business days for OTC derivatives; two business days for financial instruments other than OTC derivatives”.

The head of regulatory policy at a clearing house says: “The PFMIs stop short of putting specific numbers on margin. National regulators then put in place additional detail. In legislating for Emir, regulators would have walked around the market and seen what was normal business practice. Those MPORs effectively reflect that the OTC market is generally less liquid than the ETD market, particularly where you don’t have a centralised order book in order to help a CCP manage a liquidation.”

Asked whether international regulatory standards should be overhauled, the market infrastructure supervisor at a European prudential regulator says: “I think we keep them under regular review. There was updated CCP resilience guidance published by CPMI-Iosco to supplement the PFMIs recently. We have followed up with our CCPs to make sure they have taken action where they need to be in line with the additional guidance.”

Sweden’s financial supervisor, Finansinspektionen, says it is “too early to say” whether the PFMIs need updating. Instead, FI is focused on promoting the development of a European framework for recovery and resolution for CCPs, which has currently stalled in the EU legislative process.

An FI spokesman says: “Systemically important banks must have recovery plans and the possibility of resolution in the event the bank suffers major financial problems. There are at this time no similar legislative requirements on CPPs at either the EU level or in Sweden. A resolution framework would increase the possibilities for a CCP to continue to offer critical services – services that are necessary for the markets to function well – even if it suffers serious financial problems.”

The US Commodity Futures Trading Commission was unable to respond to’s questions in time for publication.

Editing by Philip Alexander

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