Default at NASDAQ Clearing
By Jake Pugh

Monday September 17, 2018


An inopportune moment for a failure of risk management at a CCP:
“Trader blows €100m hole in Nasdaq’s Nordic power market.”


Lehman Brothers filed for Chapter 11 bankruptcy protection on September 15, 2008 – the largest bankruptcy filing in U.S. history.


In the wake of the Lehman insolvency and the ensuing financial crisis, a central plank of the regulatory and capital reform agenda of the last 10 years has been to migrate bilateral OTC derivatives flows into Central Counterparties (CCPs). This was a key element of the G20 response in September 2009: “Improving over-the-counter derivatives markets: All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.”


Whilst the migration of OTC flows into CCPs has been slower than intended in the G20 communiqué, the ‘cleared’ market has significantly increased its share of the OTC derivatives markets. According to ISDA and BIS data, the cleared IRS market has risen from circa 21% to over 75% in ten years. CCPs now clear over 55% of the credit market – up from zero in 2008.


The insolvency at Nasdaq Clearing could scarcely be more poignantly timed; especially as many banks have been arguing that CCPs now represent the new single point of failure due to concentration and contagion risks. It’s a startling tale – Nasdaq had only €7m skin-in-the-game (SITG) and, given the insolvent member was self-clearing, the CCP had total visibility on open positions.


Nasdaq European Commodities CEO is reported to have said: “I think it’s an extreme situation. These two markets have always been correlated when it comes to price movements”. The size of Aas’ portfolio had been “out of the ordinary” and “It was a very specific situation with a lot of movements that led up to this”.


If these attributed quotes are true, it is an extraordinary failure of the risk management regime. Once historic correlations that drove margin levels had started to break down, the CCP should have applied concentration or add-on margin. By not adjusting IM levels dynamically, the CCP was effectively taking the same bet as Aas but against the default fund contributions of the other clearing members.


Regulators, central banks and prudential authorities worldwide will be paying very close attention in the coming weeks. Nasdaq has meanwhile added €19m of capital into the CCP – but only for an interim period.


This is a MAJOR market event and particularly taking place on the 10th anniversary of the Lehman insolvency. It highlights significant weaknesses in key elements of the EMIR regime and there are likely to be a number of significant implications for EU CCPs and clearing members:


1. A review of EMIR, especially with regard to the risk governance regime, the
College structure and dynamic margin adjustments (different of course to intraday margin calls);
2. CCPs will likely be required to undertake an urgent review of the entire risk framework: membership requirements, margin models, Default Fund sizing, backtesting and stress testing, CCP monitoring and escalation regime, capital requirements, SITG, risk governance, default management processes, etc.;
3. May lead to a prudential analysis of Exchanges with multiple CCPs focused on the allocation of capital across multiple CCPs and SITG funding;
4. Clearing members will push for more transparency on CCP risk models;
5. Likely to be negative for portfolio margining initiatives as, irrespective of correlations, the net effect is reduced collateral at the CCP;
6. Clearing members may seek to adjust the economics of central clearing given that risk/reward appears imbalanced between CCP and clearing member. The CCP captures most of the clearing revenue benefits in benign conditions but the non-defaulters pick up the tab under member insolvency. Moral hazard?;
7. Banks will lobby for higher clearing member capital requirements;
8. This will likely squeeze non-bank independent clearing members – a number of which focus on clearing commodity markets;
9. Further delay the introduction of the CCP resolution regime. Given that resolution sits at the end of the waterfall, it’s rather important to ensure all the other links in the chain work effectively (!); and
10. May impact the prop trading community if the cost of clearing increases.


There are a number of other interesting market implications:


• New Exchange/CCP business initiatives are increasingly likely to follow a partnership model in which all revenue streams are balanced between all participants (e.g. Swapclear, LME Precious, CurveGlobal);
• The ongoing EU spat between ESMA and the ECB over CCP oversight will be resolved – and ECB will win;
• The timing is remarkable coming hot on the heels of the comments of Chris Giancarlo around the international equivalence regime at the Eurofi Financial Forum. The EU will be under further pressure to show deference to equivalent international standards;
• This event exposes some of the wilder accusations in the Euro clearing debate. Some have recklessly argued that the UK CCPs might compete on risk post- Brexit; a particularly irresponsible claim given that the BoE ‘gold plates’ EMIR client margin requirements for rates and credit; and
• Given the potential implications for the independent non-bank clearing community, Fosun may re-evaluate the potential purchase of Marex.


17, September 2018
Jake Pugh

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