Fernando V. Cerezetti and Luis Antonio Barron G. Vicente
A vestigial structure is an anatomical feature that no longer seems to have a purpose in the current form of an organism. Goosebumps, for instance, are considered to be a vestigial protection reflex in humans. Default funds, a pool of financial resources formed of clearing member (CM) contributions that can be tapped in a default event, are a ubiquitous part of central counterparty (CCP) safeguard structures. Their history is intertwined with the history of clearinghouses, dating back to a time when the financial sector resembled a Gentlemen’s Club. Here we would like to address the following – perhaps impertinent – question: are current mutualisation processes in CCPs a historical vestige, like goosebumps, or do they still hold an important risk reducing role?
The Evolution of CCPs
The history of CCPs dates back more than 100 years – see Norman 2011 for an elegant perspective. Although the evolution from trading associations (boards or exchanges), to clearing corporations and later to central counterparties may seem natural, historically the developments were not so straightforward. CCPs emerged gradually as a result of experience and experimentation – for instance, Caisse de Liquidation in Le Havre was introduced in 1882, followed by London Produce Clearing House in 1888, CME in 1919, NYSE in 1920, and CBOT in 1925.
In the past, clearing membership was a key policy to mitigate counterparty risk. Typically, members were only accepted after some history on the trading floor or if they were already well-established in the clearing business. Measures such as suspension or expulsion were also used to enforce compliance with contractual terms. Complementing these rules, usually some non-mandatory and basic forms of initial margin existed.
The advance of futures markets in late 19th century accelerated the expansion of the clearing business. This new world exposed the limitations of the clearing structure, and the conditions for the appearance of central counterparties guaranteeing settlement emerged. Most importantly, CCPs surged as new and independent corporations, building up capital to mitigate rising risks. Commonly shares were issued, and subscriptions were mainly centred at trading members.
Initially some CCPs did not establish default funds. In this case callable capital would act as a mechanism to mitigate losses arising from the default of a member. Other CCPs opted to formally constitute default funds, segregating a fraction of their members’ capital. One way or another, accountability and ownership were intrinsically bound, and mutualisation was a natural outcome.
The Case for Mutualisation
There is no shortage of arguments in favour of using default funds as a means of increasing CCP resiliency that transcend the mere fact that more resources are available to withstand a default – see Gregory (2014), and references therein, for a comprehensive discussion. Indeed, default fund mutualisation is often viewed as a way of aligning incentives, encouraging clearing members to take an active role in the risk governance of the CCP, especially concerning the composition of the safeguard structure and the definition of admission/participation criteria. Likewise, clearing members are incentivised to monitor the credit quality of their peers on an ongoing basis. Default funds also play an important role in reducing the cost of clearing, since tail risk is diluted across a large number of participants.
The Times They Are A-Changin’
As CCPs evolved, however, some of these arguments became less meaningful. For instance, the case for aligning interests via default fund mechanisms. Because the current norm is to employ some share of CCP´s own capital before default fund resources (skin-in-the-game), the balance of incentives now tilts more towards the CCP concerning pre-default fund risk management. Also, in demutualized, for-profit CCPs, clearing members have few (if any) opportunities for “blackballing” new entrants, as opposed to the old Gentlemen´s Club structure.
Moreover, CMs’ accountability through mechanisms previously deemed as minor and somewhat obscure, such as default fund replenishment rules and contribution reassessments (not to mention the ranking of contributions during the re-establishment of a matched book), have gained greater importance lately due to regulation and their central role in CCP resiliency and recovery.
Replenishment rules define how CCPs should react to a default fund shortfall due to one or more defaults, striking a balance between (i) maintaining minimum coverage amounts (CPMI-IOSCO 2016) and; (ii) limiting total (surviving) clearing member liability. Most CCPs’ rulebooks prescribe such rules nowadays, although debate continues on how to ensure clearing members’ financial and operational capabilities in times of market stress.
The reassessment frequency of default fund contributions determines the way CCPs manage the fund’s coverage. CCPs that rely on fixed contributions often lack a reassessment schedule, so default fund sizes remain virtually static for years, the only changes reflecting fluctuations in the number of active CMs. Accordingly, the default fund coverage diminishes as markets become bigger. For instance, as presented by HKEx Securities Clearinghouse self-assessment, from 1992 until 2012 ADV peaked $88.1bn from $3bn (29.4x), but default fund size increased only from $105m to $245m (2.3x). To tackle this and other relevant issues HKEx carried out a comprehensive reform in 2012, moving from fixed to dynamic reassessments. Contributions to dynamic default funds comprise a fixed minimum plus a variable amount expressing some function of the clearing member´s average risk exposure, reassessed on regular basis. The approach is sensible from a risk management standpoint, and aligned with current regulations and best practices that call for risk-adjusted default funds.
In Theory There is no Difference Between Theory and Practice. In Practice There is! (Snepscheut)
A major problem in trying to analyse the effectiveness of default fund mutualisation is the absence of relevant incidents during what we regard as CCPs´ modern period. Indeed, even Lehman´s debacle was not enough to test major CCPs´ default funds. Nonetheless, it is worth examining what happened to KRX in December 2013, when HangMag, a derivatives dealer with capitalisation of just $20 million, defaulted with losses summing more than $45 million. Because KRX did not have any skin-in-the-game at that time, all losses in excess of initial margin had to be absorbed by the default fund. Notwithstanding the fact that not having skin-in-the-game was not a standard practice (CPSS-IOSCO 2012), this situation represents an extreme case in which CMs should, according to the theory, be particularly vigilant concerning initial margin requirements, risk monitoring processes and participation criteria, as their funds were the first line of defence once exhausted all defaulter´s collateral. So much for the theory, as surviving clearing members had to pay for the losses – see Vaghela (2014). This example also sheds some light on the actual challenges of default fund replenishment. Although the event happened on 12 December 2013, only on January 20 most members of the exchange had replenished the default fund, with KRX offering some flexibility until March as a final deadline.
Old, But Not Obsolete
All things considered, saying that default funds are evolutionary vestiges condemned to oblivion would be precipitate. As the KRX example illustrates, the default fund performed as expected. Yet, in a similar way to what happened to initial margin requirements, default fund mechanisms need to continue evolving and adapting to the new CCP environment. Replenishment procedures would benefit from regular review and testing, and contingency measures need to be put in place to maintain risk coverage. It is not a coincidence that CPMI-IOSCO (2016) noted that “While some of these CCPs have put in place interim measures to ensure that they can nevertheless continue to meet coverage standards, others have not; for these latter CCPs, it is unclear how they would ensure a timely return to full coverage following a depletion of resources.”
Although superior vis-á-vis their static counterparts, dynamic default funds also need some rethinking, as the model begets important (often overlooked) implications. First, there is an inherent free-riding effect (i.e. one member paying for the risk of another) due to mutualizing different amounts, which is obvious in the case of new entrants and fast-growers that benefit from a “grace period” in-between default fund reassessments. Next, locking-up capital based on past risk profiles could, in some circumstances, complicate crisis management actions. Care should be taken to ensure that measures originally designed to mitigate risks do not make resolution more complex, as discussed in Perrow (1999) excellent account of high-risk systems. Moreover, bigger exposures do not necessarily mean higher default probabilities, especially because: (i) positions might be hedged outside the CCP and; (ii) larger CMs usually have to observe tighter capital requirements.
Hence one could argue, from a credit risk-adjusted standpoint, against a “pay-by-weight” mutualisation scheme – adding insult to injury, contributions to a mutualized default fund feed into banks’ capital charges. There is a strong case, for instance, for exempting the variable amount from participating in the mutualisation process. This should not impact the dynamic default fund´s minimum coverage. However, besides assuaging replenishment uncertainty, less mutualisation would ease free-riding and capital cost problems. More about this in a future post.
Luis Antonio Barron G. Vicente is a former Managing Director, Risk and Clearing at MOEX. Fernando V. Cerezetti works at Risk, Research and CCP Policy.
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