Risk Waterfalls Webinar – When do I start to lose my money? A summary of the key points
The shift to centralised clearing of swaps does not eliminate risk. It transfers it to CCPs. It follows that the risk management practices of the CCPs, including their membership criteria, margining methodologies, collateral segregation policies and especially their own 'skin in the game' are matters of more than academic interest to fund managers and their clearing brokers. In particular, it is essential to understand the so-called 'risk waterfall,' or the sequence in which capital and collateral is called in any event of default, is structured at every CCP.
COOConnect held a webinar on the topic featuring Andrew Lamb, CEO at CME Clearing Europe; Renaud Huck, head of buy-side relations at Eurex Clearing; and Stephen Loosley, managing consultant in the clearing, risk and regulatory team at Catalyst. The webinar was moderated by Dominic Hobson, founder of COOConnect.
Here is a summary of the key points from the discussion
- Although broadly similar, central counterparty clearinghouses' (CCP) risk waterfall policies vary by geography.
- An established CCP will typically have five lines of defence before it runs out of resources to handle a clearing member default, at which point buy-side firms could be called upon for additional collateral. The first layer of protection is initial margin, followed by defaulting member’s default fund contribution, CCP contributed capital, and lastly non-defaulting members' default fund contributions. After the last stage, CCPs are in unchartered territory. At which point, it is assumed the CCP will wind down its affairs and declare insolvency.
- There is debate as to whether buy-side clients could be impacted by a CCP failure or clearing member failure. The European Markets Infrastructure Reform (EMIR) allows for clients to opt for their non-cash collateral to be stored at fully segregated accounts at CCPs. However, if buy-side clients choose a co-mingled account, and a CCP or clearing member runs into trouble, the collateral could be caught up in the on-going proceedings. Cash collateral is not afforded this luxury as it is utilised by CCPs to monitor day-to-day liquidity positions. Therefore client cash collateral is at risk from a CCP or clearing member default. London and European CCPs tend to have more cash collateral relative to non-cash collateral than their US counterparts.
- In terms of where collateral is stored, regulators have made it abundantly clear they prefer CCPs to store securities collateral at central securities depositaries (CSDs) as opposed to custodian banks whereas cash collateral is stored in a custody account.
- The great unknown is what happens during a CCP default. CPS IOSCO and the Bank of England have outlined documents suggesting CCPs identify how any potential losses are allocated. CCPs acknowledged a default was unchartered territory but most active CCPs in Europe, North America and Asia are likely to have internal rule books outlining the default management process. However, these rule books do not cover or assess the implications for end-users or buy-side firms.
- Nonetheless, much of the onus is on clearing members and their ability to effectively port client positions to another clearing member and CCP in the event of difficulty. The ability to port positions in the most effective manner possible is likely to be costly, and different account structures (IE more efficient portability) will incur higher fees from buy-side clients..
- In the US, buy-side collateral will be held at CCPs under the legally separate operationally co-mingled (LSOC) structure. However, a growing number of buy-side firms are asking for higher levels of protection and asking for individually segregated accounts, which will cost more.
The webinar replay in available in both audio and video form - click on Risk Waterfalls Webinar to access the replay.