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Can Central Counterparties fail?

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With the implementation of EMIR, clearing will become mandatory for many companies, also for non financial companies active in the (energy) commodity markets. The result would be that these companies will be dealing only with one or two Central Counterparties (CCPs). Leaving them exposed to one single entity; the CCP. In other words they are facing a concentration risk, that will materialize when a CCP would default. The big question is what are the odds that a CCP could go bankrupt?

CCPs will tell you that due to their own highly advanced risk management capabilities , prudent supervision and capital requirements it is highly unlikely that they will fail. That’s right, just like banks before 2008.

Also history does not back up this claim. In recent decades three clearing houses have failed and in 1987 the clearing system in the US was at the brink of collapse.

In 1974, the Caisse de Liquidation failed in Paris, due to default on margin calls when sugar-futures prices fell sharply.

In 1983, the Kuala Lumpur Commodities Clearing House went down, when half a dozen large brokers defaulted following a crash in palm-oil futures.

In 1987, the Hong Kong Futures Exchange clearing house failed in the wake of the global stock market crash of that year. The effects were devastating. The Futures Exchange had to close. Traders had hedged margin-financed cash equity positions in the futures market. They faced margin calls on their cash positions but, with the futures market closed and the clearing house bust, they could not get margin moneys returned on their profitable futures positions. For that and other reasons, the stock market closed too. The upshot was that Hong Kong’s main capital market shut down. Reopening the market was no small feat. World markets had fallen further in the meantime, so there was a risk that a modestly ‘recapitalised’ Clearing House would go broke again if positions had to be marked down immediately. In the event, the Hong Kong Government and the clearing banks underpinned the Clearing House.

In 1987 there was also a near collapse of the US clearing houses during the stock market crash in October that year. The CCPs could only be saved by intervention of the FED.

What could cause a CCP default

A CCP default, if it occurs, would typically follow the default of one or more member firms. A recent example of this is Lehman Brothers, however, this default did not bring down any clearing house. But what if Lehman would have taken down other banks/ Clearing Members in their collapse? A member firm could default because it is insolvent, or because it is insufficiently liquid to meet a margin or delivery settlement obligation. If one or more member firms are defaulting and margin with the CCP is insufficient to cover its (their) obligation, the CCP would have to call upon other financial resources, including its equity and default fund and its ability to call on additional capital contributions by members. If all of these resources are exhausted as a result of the member default(s), the CCP would default on its obligations to other members and their clients.

A CCP could also default due to a lack of liquidity. For instance, in the event of a member default, the CCP is obligated to make a timely payment to those owed variation margin payments. This will require the CCP to liquidate the defaulter‘s (defaulters‘) collateral, and perhaps some of its own assets. The CCP may also attempt to borrow to meet its obligations. If such collateral sales and borrowings occur during stressed market conditions (which is when a large member default is most likely), the CCP may be unable to raise sufficient funds to meet its obligations in the short time available to do so.

Of course there are also several positive examples that despite the default of one or more very large player(s) in the market, the clearing system did easily survive. A good example of this is the demise of Enron in 2001. This bankruptcy of one of the most significant players in the US and European electricity and gas markets, did not cause a problem, whatsoever, with any of the clearing houses of the energy markets Enron was active on.

The conclusion is that the probability of a clearing house going bust is very low, due to well-structured and capitalized CCPs. But it certainly is not impossible, and the impact would be devastating to the entire financial system.


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