Banks warn of trader crunch at CCP default auctions

Risk USA: dealers hope for more cross-CCP fire drills


Clearing houses need to more effectively co-ordinate default auction management between their peers and their members to avoid a looming resource crunch in the event of multiple defaults, banks have warned.

The default of a lone power trader on Nasdaq’s Nordic futures market last September, which saw the bourse botch the auction to sell off the defaulter’s portfolio, has set in motion a year-long debate over CCP default management, with banks, central counterparties and regulators all expressing strong views on the way default auctions should be run.

Nasdaq was variously accused of not inviting enough participants to the auction, and failing to flatten the heavily directional portfolio’s risk through pre-auction hedging to make it palatable to buyers the first time around. The auction then had to be rerun – locking in an unnecessarily large loss, some members argue, which extinguished two-thirds of the CCP’s default fund.

Speaking during a panel debate on CCP risk during Risk USA on November 5, Marco Ossanna, chief risk officer, US futures commission merchant, HSBC, put it bluntly.

“They screwed up. They had no concentration [margin] add-on or enough of a concentration add-on to protect against such an event,” he said, meaning there was an insufficient margin period of risk on the positions to give the CCP long enough to safely close them out once the trader defaulted.

For more complex futures and over-the-counter portfolios, where a clearer may lack a liquid market on which to liquidate the positions, members routinely second traders to a CCP’s default management group (DMG) to help it close out the defaulter’s portfolio at a minimal loss to themselves. Nasdaq Clearing’s DMG for futures did not include any bank traders – a critical misstep in the eyes of some clearing experts.

However, seconding traders could also pose problems for banks in the event of simultaneous defaults by large members at multiple CCPs, noted Ossanna – leading to a brain drain among large clearing brokers, who could be obliged to send traders to CCPs across the globe amid nosediving markets.

This could be an acute issue for firms that transacted in certain currencies, particularly currencies with less deep fixed income markets, such as the Hong Kong dollar or New Zealand dollar, added Ossanna.

“It could be that we only have one trader in the world, or two traders,” he said. “If you second on that, that would be a problem.”

A June paper between the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions, news of which was first reported by, suggested CCPs and their members could agree a limit on the number of traders that can be seconded from a certain clearing product “at any one time”.

Ossanna said some CCPs had already moved on this issue, after a cross-CCP fire drill a few years ago revealed several traders at large banks were scheduled to simultaneously advise several CCP DMGs.

“Some CCPs have been hearing us in terms of how to schedule the secondment out to make sure that we are not depleting our desk in some way because [of] our trades and we need to make a bid as well. Or that we need to deal with the situation probably in the market,” he said.

However, more co-ordination was needed in situations where CCPs competed on the clearing of identical products, added Ossanna.

One avenue CCPs and their members could take to improve co-ordination in the event of a default would be to run more cross-CCP fire drills

“What I think is still missing is co-ordination between maybe CCPs in such a way that some CCPs are covering the same kind of products. And so, it could be if there is not a co-ordination between CCPs, then you have a situation in which the same trader could be asked to participate in the same hedging exercise or for a different CCP. I’m hoping we’ll see more of that.”

One avenue CCPs and their members could take to improve co-ordination in the event of a default would be to run more cross-CCP fire drills – simulating real-world conditions in a default, in which the largest members of one CCP were likely the same as another, given the concentration of clearing among the same handful of firms.

Last year, CCPs including CME and Eurex took part in a cross-CCP fire drill. Indicating he would not be opposed to the idea of further such initiatives, Sunil Cutinho, CME Clearing president, added: “We have a working group between CCPs – expect for one in London that does not want to participate – where we co-ordinate which firms at which firms by currency are on hand.”

Cutinho was referring to LCH’s SwapClear, by far the largest swaps clearer globally.

Another critical issue in auction management is the number of parties invited to bid. Raj Ramaranth, executive director, JP Morgan, said a robust process that included a “transparent management plan” was critical for unwinding after a default. She added that the Nasdaq episode had altered thinking on the issue.

“I think there is a fine balance to be played in terms of how many people you invite to participate in the auction, how many people would like to participate. And what various impacts [that would have on] on the price,” said Ramaranth.

In contrast to the auctions held at CME Group for Lehman Brothers’ portfolios after the firm failed during the financial crisis, Suzanne Smore, chief risk officer and global head of counterparty risk at State Street Global Advisors, noted that the number of bidders for assets held by the firm was quite small, suggesting default auctions should routinely be opened up to outside bidders to secure a better price, minimising mutualised losses.

“The broader number of constituents that you’re offering to auction, your likelihood of getting a very competitive bid is the benefit of all parties,” she notes. “The Lehman auction was competitive. It went outside the clearing members. I think a prop desk probably was a pretty active aggressive bidder. And in that scenario, only a third of the initial margin waterfall was used.”

Editing by Tom Osborn

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