The busted auction at Nasdaq Clearing has laid bare divisions over the role of banks in clearing house default management groups (DMGs).
In one camp are those who want to send in their traders to help close out a defaulter’s portfolio, and in the other are those who say the absence of their traders would leave them dangerously understaffed in a market meltdown.
“DMGs are critical,” says a risk manager at a large bank. “Nasdaq’s DMG does not have any member representatives. That’s a bit of a gap, to say the least. Seconded traders … have the market expertise to support that close-out process, to help realise a sensible price.”
A clearing expert at a second large bank is less enthusiastic about compulsory member participation in clearing house DMGs, in part because big dealers can have memberships at dozens of clearing houses, and could be compelled to support multiple auctions simultaneously.
“We wouldn’t want to be in a position where, for all of our memberships, we’re mandated to send a trader, because it takes them off the desk in a time of crisis,” says the expert.
Norwegian energy trader Einar Aas defaulted on September 10 after being caught on the wrong side of a bet on the spread between Nordic and German electricity futures. The clearing house was forced to rerun its default action after its first attempt failed, and the second auction crystallised a €114 million ($129.1 million) loss, prompting anger among members.
Nasdaq Clearing’s DMG for futures does not include any bank traders – a critical misstep in the eyes of some clearing experts speaking to Risk.net. Instead, it features numerous Nasdaq executives – including the firm’s chief executive, chief risk officer and head of clearing operations – as well as representatives of global risk management and from the communications department.
DMGs are convened to help CCPs make decisions during the default management process, including: whether or not to liquidate a defaulter’s portfolio on exchange; whether and how to hedge parts of it; and how to slice it up and ready the subsequent segments for auction if needed.
At swaps clearing houses, banks typically second traders to advise on the CCP’s management of defaulters’ portfolios, on a rotating basis. In futures clearing, however, practices vary far more widely.
Futures clearing houses may choose to flatten the risk posed by a defaulter’s portfolio by entering into equal but offsetting transactions on exchange, if the underlying market is liquid enough. Alternatively, or in addition, a CCP may pursue an independent sale of the defaulter’s portfolio, or resort to an auction, in which market participants can bid for their unmatched positions – something that is typically done for portfolios composed of less liquid futures, as was the case for Aas’s power trades on Nasdaq Commodities.
As we live in a constrained world with trading more and more electronic, there are often not that many traders any more – and you can’t send an algorithm to a CCP
Ulrich Karl, Isda
CCPs and even some regulators have long warned of a resource crunch, should there be multiple, simultaneous defaults – leading to a brain drain among large clearing brokers, who may be obliged to send traders to multiple CCPs across the globe amid nose-diving markets. During a cross-CCP fire drill a few years ago, several traders at large banks were reportedly surprised to discover they were scheduled to simultaneously advise several CCP DMGs.
The issue came to a head as the International Swaps and Derivatives Association was preparing a paper on central counterparty (CCP) risk management best practice in the wake of the Nasdaq default, which was published in late January. During its drafting, at least one large bank was adamant the language in the paper should be softened, according to two sources. The bank wanted to make sure the paper did not “mandate” bank participation in the DMGs of too many CCPs, and asked for specific language to make sure this wasn’t the case.
Isda declined to comment specifically on the language used in the paper.
“As we live in a constrained world with trading more and more electronic, there are often not that many traders any more – and you can’t send an algorithm to a CCP,” says Ulrich Karl, head of clearing services at Isda. “In over-the-counter derivatives, there was consensus that there should be mandatory DMG participation. In listed CCPs, where the auction is an option in most cases, it was felt that a CCP should at least offer DMG participation to members.”
Isda’s paper says CCPs “should consider establishing a DMG, at least if the auction is mandatory”, adding that member participation could be voluntary if an auction is “just one tool” to liquidate portfolios.
In a subsequent footnote, the paper adds: “Further work on this topic will be conducted as part of the industry response to the Iosco auction design work.”
Global regulators, including the International Organization of Securities Commissions, are scrutinising CCPs’ auction processes in the light of losses at Nasdaq Clearing – a process that will include reviews of how CCPs co-ordinate between one another and share information in the event of a cross-member default.
Eurex is a prominent exception to the norm among futures clearers. For its listed derivatives business, the firm appoints default management committees with two to four clearing member representatives, with one specialist committee formed for each product liquidation group, such as equity derivatives.
Other CCPs are more hesitant to tap clearing members for their DMGs. “I wouldn’t rule it out [inviting clearing members to DMGs], but we do have a risk committee in futures and options products that we can go to in an advisement role, during a default,” says Lee Betsill, chief risk officer at CME Clearing.
“But, generally speaking, listed products are much simpler, and the inherent risks of the portfolios are more easily identifiable. Exchange-traded contracts are more liquid, and there is an order book we can go to for liquidation.”
Multiple CCP risk experts speaking to Risk.net argue that having greater trader expertise on hand at listed clearing houses would be a good thing – but acknowledge the difficulty of demanding firm commitments from members. Many voice concerns that, during times of crisis, where multiple CCPs have to deal with auctions all at once, trading desks face being drained of their best talent, hampering their ability to continue normal operations.
CCPs do employ their own traders, and populate their risk management teams with former traders – but market participants point out that DMGs need a blend of current market experience when handling a live default.
“CCPs can’t hire a trader on the basis that there might be a default in five years’ time, because it’s a very boring job, and he or she will no longer be current in the market,” says the head of clearing at a third large bank. “So you need current expertise. But as a dealer, that resource is then lost to you. To be honest, this is more of an onerous obligation of membership, rather than an opportunity.”