BIS slams Nasdaq Clearing for risk management failures

Clearing member says it is giving notice to quit bourse, citing concerns over concentration of risk on venue

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The Bank for International Settlements has issued a stern rebuke to Nasdaq, blasting the clearing house for risk management failures that led to a €114 million ($130.1 million) loss for clearing members earlier this year.

In a report published in its latest quarterly review, the watchdog makes unfavourable comparisons to central counterparties’ (CCPs) handling of the default of Lehman Brothers – which, in the case of the bank’s cleared rates portfolio, did not see losses mutualised. BIS staffers Sarah Bell and Henry Holden write: “Sound risk management and preparation make all the difference between a CCP that absorbs a shock, and one that propagates it.”

The report comes as one of the CCP’s general clearing members tells it has decided to quit the venue in the wake of the episode, citing concerns over its risk management practices. Nasdaq declined to comment.

During the unwinding of Lehman’s interest rate swaps cleared at LCH in London – comprising some 66,390 trades worth a notional $9 trillion – only about one-third of the bank’s initial margin pool was used up. “Yet 10 years later, a single trader with a much smaller portfolio presented a CCP with a much greater challenge,” says the BIS report.

In September 2018, losses suffered by commodity trader Einar Aas were large enough to blow through the defaulter’s initial margin. Following a rerun of the default auction, the CCP tapped its default fund, mutualising the loss between the 215 members of Nasdaq Commodities.

Aas was betting Nordic and German electricity prices would converge, but changing weather patterns and a shift in German carbon emissions policies instead pushed prices further apart. On September 10, a market move created a loss 39% larger than the CCP’s margin model was designed to cover. When Aas failed to pay a margin call to Nasdaq Clearing in Sweden, he was declared in default the next morning.

Nasdaq did not deem the loss-making positions large enough to warrant a margin add-on for concentration risk. Nasdaq has since been scrutinised for its risk management processes, the auction that the clearing house conducted to sell off the loss-making positions, as well as a lack of clarity surrounding how it shared information about the event.

“For a CCP to exhaust a defaulter’s collateral is unusual, even in the case of a large default such as Lehman’s,” the report notes. “The Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions [offer] guidance on how CCPs should set their margin to prevent this from happening. The guidance includes calculating initial margins using a sufficiently long time horizon, using assumptions on how liquid the market is, and allowing only for prudent offsets between products.”

Nasdaq calculated Aas’s initial margin requirements by requiring him to pay 99.2% of the biggest two-day market movements over the previous year, plus 25% of the biggest two-day movement that year; but the CCP also gave Aas a correlation offset of 50% on the margin, and he was not required to pay additional margin even though the position made up a large proportion of the open interest in that segment Nordic power market.

A regulator responsible for overseeing financial market infrastructures suggests granting margin offsets would have made sense if the electrical grid allowed the transmission of power from Norway to Germany, or vice versa, “but that is not the case”. NordLink, the first direct connection between power markets in Germany and Norway, is due to start commercial operations in 2020.

Some observers have suggested that margin-setting may sometimes reflect competitive pressures

BIS report

“[Offering] margin discounts for spreads isn’t unreasonable in concept, as the margin levels are usually calibrated on the outright position. That said, 50% seems like an awfully round number,” says the head of clearing at one European bank. In many value-at-risk-based models, spreads are implicitly included because of the nature of the model, he notes.

The reasons for Nasdaq’s margins proving insufficient are unclear, Bell and Holden add, “but some observers have suggested that margin-setting may sometimes reflect competitive pressures”.

This is an analysis with which one of the bourse’s general clearing members in commodities agrees. The firm tells it is planning to quit the CCP in the wake of the debacle.

Its head of futures and options says: “Right now, we’re making sure that we’ve still got full recourse to reclaim any funds before submitting our notice to quit.

“What were Nasdaq doing? They should not have ended up in this situation. They shouldn’t have had one person taking such concentrated risk on their venue. And if they did, they should have massively lifted margin and default fund contributions. They put all their other members at risk. We are beholden to CCPs, and they should be more of a utility function, but they are actually very commercially driven.”

A refreshing change

Market participants welcome the BIS’s unusually forthright intervention. “It is refreshing for an institution like the BIS to be so direct and damning. I hope the lessons will be learned. It reinforces the need for strong governance at CCPs including appropriate independence of the risk function coupled with appropriate regulatory oversight,” says Christian Lee, a clearing, risk and regulation expert at consultant Catalyst.

“This was a startling failure of risk management at many levels. Clearly there was a massive failure at the margining level. Once the spread had started to blow out, why didn’t they raise margins? By not increasing margins, the CCP was effectively doubling down on Aas’s trade, but with the clearing members’ money,” says capital markets consultant Jake Pugh.

Alexander McDonald, CEO of the European Venues and Intermediaries Association, agrees, saying that a lesson that may emerge for futures commission merchants is for them to favour “a few big global CCPs, rather than lots of small ones with risks that are harder to model”.

Editing by Tom Osborn

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