Clearinghouses Are Raising Their

Game--But They Are Not Risk-Free

Primary Credit Analysts:
Thierry Grunspan, Paris (33) 1-4420-6739; thierry.grunspan@standardandpoors.com
Samira Mensah, Johannesburg (27) 11-214-1995; samira.mensah@standardandpoors.com
Secondary Contacts:
Charles D Rauch, New York (1) 212-438-7401; charles.rauch@standardandpoors.com
Giles Edwards, London (44) 20-7176-7014; giles.edwards@standardandpoors.com
Table Of Contents
A Brief History Of Clearinghouse Failure
Types Of Exposures to Clearinghouses
New Regulation Has Strengthened The Quality Of Financial Safeguards
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Clearinghouses Are Raising Their Game--But They
Are Not Risk-Free
Throughout the 2008-2009 global credit crisis, clearinghouses were a stabilizing influence for unnerved investors and
traders. All the clearinghouses we rate completed their clearing and settlement obligations in a timely manner and
without incident of loss to either themselves or their members. Since then, regulators worldwide have conferred more
responsibilities to clearinghouses, also known as central counterparties (CCPs), recognizing that their resilience in a
crisis could aid the stability of the financial system. The U.S., for example, introduced mandatory clearing of
over-the-counter (OTC) derivatives by CCPs in 2013 as part of the Dodd-Frank Act, and the EU plans to follow in 2015
under the European Market Infrastructure Regulation (EMIR). As a result, the members of clearinghouses and
non-members will face increased exposure to CCPs.
Although clearinghouses are in many ways better equipped than individual banks to handle counterparty risk, they are
not risk-free. Although instances are rare, clearinghouses have defaulted in the past. Furthermore, the regulations on
CCPs in the U.S. and the EU, rather than eradicating risks for the financial system as a whole, are in our view
transferring risks to clearinghouses.
Overview
Standard & Poor's believes clearinghouses are generally well positioned to meet the new responsibilities and
risk that regulators worldwide are transferring to them, particularly in the clearing of over-the-counter (OTC)
derivatives in the U.S. and the EU.
Regulatory changes under Basel III recognize this risk and require banks to maintain capital against their
exposure to clearinghouses.
Although the new regulation has strengthened the quality of financial safeguards, especially in the EU and in
the U.S., we believe that competition for business may tempt some clearinghouses to lower their financial
safeguards.
In recognition of the growing exposures that clearinghouses handle, the Bank for International Settlements (BIS)
requires banks to maintain capital against their exposure to CCPs under the new Basel III regime. This is a new
development compared with the former Basel II regime, under which exposures to CCPs are viewed as risk-free.
Standard & Poor's Ratings Services, which surveils 13 clearinghouse operators worldwide (mainly as part of rating their
parents), considers that regulation aimed at strengthening the robustness of financial safeguards for CCPs is a positive
development. We nevertheless believe the quality of financial safeguards could increasingly differ among
clearinghouses as they compete with each other for business, with some tempted to relax financial safeguards to
attract new customers.
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A Brief History Of Clearinghouse Failure
Although rare, clearinghouses can and do fail. In some cases, clearinghouses have suffered a "sudden death" by being
unable to complete settlement obligations in a timely manner. In other cases, they have suffered a slow death by
gradually losing business from their associated exchange if traders migrate to a competing venue.
Among the three most famous clearinghouse failures in recent history, the Caisse de Liquidation, an independent
commodities clearinghouse in France, was hit by a sharp and sudden correction in the price of sugar in November
1974. The Caisse was slow to react and several members, including one with a very large position in sugar, did not
meet their margin calls. Consequently, the French Ministry of Commerce closed the market.
In a second case, the Kuala Lumpur Commodities Clearing House was hit by a price squeeze in palm oil when one
large member tried to corner the market in that contract in February 1984. The clearinghouse was slow to respond to
the unusual trading activity. When it did adjust margin requirements, several large players defaulted and trading was
suspended.
Third, the Hong Kong Futures Guarantee Corporation provided a settlement guarantee to trades conducted on the
Hong Kong Futures Exchange, home of the Hang Seng Index futures contract, one of the most actively traded stock
index contracts outside the U.S. It was not affiliated with the clearinghouse, ICCH (Hong Kong) Ltd. In October 1987,
the stock market crashed and the guarantee corporation had insufficient resources (only HK$15 million of capital) to
handle the massive member defaults. A HK$2.0 billion rescue package was put in place, consisting ofHK$1.0 billion
from the Hong Kong government, HK$500 million from a group of local banks, and HK$500 million from the
shareholders of the guarantee corporation.
Beyond these three high-profile cases, there have been a number of close calls; the most infamous being the Singapore
International Monetary Exchange (SIMEX). In February 1995, Nick Leeson, a trader at Barings Bank, had a 827
million losing position in futures contracts linked to the Nikkei 225 stock index. When Barings was unable to meet the
margin call, the bank collapsed and nearly brought down the SIMEX with it.
Types Of Exposures to Clearinghouses
Two different groups are exposed to a failure at a clearinghouse. The first are their members--that is entities (banks or
brokers) that clear their trades directly with the CCP, without any intermediary. Clearing members clear trades for their
own account, as well as trades on behalf of their customers. The second are non-clearing members, customers of these
member entities, who rely on clearing members to clear their trades.
Members of clearinghouses are exposed to two broad categories of risks in the event a CCP defaults or ceases to
operate:
Trade exposures, of which there are two types of exposure: collateral on deposit and derivative replacements costs;
Default contributions.
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Non-members' exposure to CCPs depends on the segregation of collateral the client posts to the clearing member.
Below, we detail these risks as well as the various regulatory requirements related to these risks under Basel III
Members' trade exposures
Collateral on Deposit. Clearinghouses require their members to post an initial (or original) margin, which acts as
performance bond or good faith deposit in the event the member defaults. Initial margin is typically designed to cover
the potential overnight (or multiday) change in price in the defaulted member's outstanding portfolio at the
clearinghouse. Initial margin collateral is typically in the form of cash or high-quality securities that the clearinghouse
collects at least on a daily basis. If this collateral is not held in a bankruptcy-remote manner (for instance, through a
custodial account held for the beneficial interest of the member), then these member assets are at risk. This is true
whether the member clears for its own account or for those of its clients.
In addition to initial margin, there is also variation margin, which represents the daily or more frequent mark-to-market
of the members' open positions. The purpose of this is to prevent members from building sizable losses on their open
positions. The clearinghouse does not hold the variation margin as it does initial margin. Instead, the clearinghouse is
an intermediary: it collects from the losers and pays the winners.
Recent legislation in the U.S., through the Dodd-Frank Act and in Europe through the European Market Infrastructure
Regulation (EMIR) requires CCPs to institute recovery and resolution (R&R) plans that are akin to living wills. To
improve their prospects in the recovery phase after a default by a major member, some clearinghouses are introducing
extra layers of protection to their own solvency. These typically involve moving any residual loss (the loss arising after
the financial safeguard package is exhausted) from the clearinghouse back to the non-defaulting members. For
example, clearinghouse rulebooks may contain loss allocation rules in which the residual loss is allocated among the
non-defaulting members and a wind-down of clearing services initiated. Loss allocation rules typically include variation
margin haircuts. Indeed, since February 2014, U.K.-regulated clearinghouses have been legally required to have loss
allocation procedures for clearing risks in their rulebooks.
We believe that a CCP would invoke loss-allocation rules only as a last resort in a desperate situation. The rated
clearinghouses have put in place financial safeguard packages that in our view protect themselves from losses arising
from member defaults in all but the most extreme market conditions. This is an important factor in our ratings on these
institutions. For this reason, we consider that the prospect of a rated clearinghouse exhausting its financial safeguard
package and invoking its loss-allocation rules is remote.
Derivatives Replacement Costs. If a derivatives clearinghouse fails, the surviving members will need to replace their
outstanding derivative positions at current market prices. For example, a bank that has centrally cleared an
over-the-counter (OTC) interest rate swap with SwapClear (an unrated unit of LCH.Clearnet Group) is exposed to loss
in the event the CCP fails. The bank's potential loss would be the difference between the current market price for a
contractually similar interest rate swap (i.e., the market price at the time the swap is actually replaced with another
counterparty than the CCP) and the market price of the swap at the last time the bank has received (or posted)
variation margin from the CCP before it failed.
The Basel III regulations require a bank to maintain a 2% regulatory risk-weight against its exposures to these two
types of trading risks if it is a member of a "qualified" CCP (meaning the CCP meets minimum CPSS/IOSCO technical
standards). If it is a member of a "non-qualified" CCP, the risk weight is 20% because BIS views the exposure as riskier.
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Default fund contributions. Most clearinghouses require their members to contribute to a guaranty fund, also known as
a default fund or clearing fund. When a member defaults, the clearinghouse expeditiously transfers or closes out the
defaulting member's open positions using its collateral--the defaulting member's initial margin and guarantee fund
contributions--to cover any losses. If the large losses exceed these amounts, the clearinghouse will use other financial
resources, including the guaranty fund contributions of the non-defaulting members, in the form laid down in its rule
books. They may also be permitted to assess the non-defaulting members to replenish the guaranty fund.
A clearinghouse's guaranty fund and assessment powers introduce "mutuality of risk" among the members. Guaranty
fund contributions are much riskier than trade exposures because they do not necessarily require the CCP to default
for banks to lose their guaranty fund contributions, either in part or in full. Clearing members could lose part of their
contribution in a scenario under which another clearing member defaults, with the CCP still having enough resources
to keep operating.
This is an important factor in our ratings on clearinghouses. Mutuality of risk provides a powerful incentive to the
members to self-police their trading activities because they are at risk in the event that another member defaults. If a
clearinghouse taps its guaranty fund or requests its members to replenish the guaranty fund as permitted in its
rulebook, we would not consider this to be an event of default.
This is what happened at the unrated Korea Exchange in December 2013, when a small brokerage company, HanMag
Securities, entered erroneous trades on the Kospi 200 Index Options contract and suffered losses that exceeded its
capital base. HanMag asked the exchange to cancel the orders, but the request was denied. The losses caused by
HanMag were so large that they exceeded its collateral (initial margin and guaranty fund contribution) on deposit at
the exchange's clearinghouse subsidiary. The clearinghouse did not use any of its own financial resources
("skin-in-the-game") to cover these losses. Instead, it used reserves set aside in the Joint Compensation Fund (i.e.,
guaranty fund) into which all members had contributed. While the clearinghouse acted within its own rules, the
non-defaulting members were upset because their funds, not those of the exchange, were prioritized to cover the
losses caused by a member default. Since this incident, Korea Exchange has amended and updated its clearinghouse
rules so that part of its own capital now stands before the guaranty funds in the payment waterfall. We also expect that
members of CCPs more generally have reminded themselves of the various default waterfalls that are in force.
Reflecting the riskiness of default fund contributions, bank regulators apply a charge of up to 100% in some instances
(meaning that guaranty fund contributions are, in essence, fully deducted from banks' regulatory capital in some
cases).
Non-member exposure to clearinghouses and clearing members
A trading firm that is not a clearing member of a clearinghouse but a client of a clearing member is also potentially
exposed to a default of the CCP. The exposure depends on the segregation of collateral the client posts to the clearing
member. There are three types of segregation in practice:
Case 1. In this framework, most commonly used in the U.S. and the EU, the collateral posted by the client to its
clearing member is legally segregated from that of the clearing member on its "house (or "proprietary") positions, but is
operationally commingled with the collateral posted by other customers of that clearing member. This is the so-called
Legal Segregation Operational Commingling (LSOC) model. In this case, the collateral posted by the client is
bankruptcy-remote from a default of the clearing member, but not from a joint default of the clearing member and any
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of its other customers. Customers could be subject to pro-rata distribution of assets in the event that another customer
defaults and causes the clearing member to default as well. Over and above a direct exposure to the CCP, the client
bears an additional risk so that bank regulators apply a higher risk weight (4 %) than the 2% pertaining to clearing
members.
As part of the Dodd-Frank Act, the U.S. Commodity Futures Trading Commission (CFTC) published new regulations
to reduce "fellow customer" risk in the clearing of OTC swaps by requiring the LSOC model of collateral segregation.
EMIR also provides for LSOC-type arrangements as a minimum requirement for CCPs. Underlying customers can also
opt for individually segregated accounts if they wish to avoid commingling not only with the member but also the
member's other customers. This corresponds to Case 2, below.
Case 2. In this framework, the collateral posted by the client is individually segregated not only from the collateral
posted by the clearing member on its "house" positions, but also from the collateral posted by other end-customers of
the clearing member. Thus, the client is bankruptcy-remote from the joint default of the clearing member and any of its
other customers. He is seen as having a direct exposure to the CCP, and regulators apply the same 2% risk weight as
that pertaining to exposures of clearing members of qualified CCPs. EMIR regulation makes it compulsory for clearing
houses in the EU to offer such individually segregated accounts services. Clearing members are free to opt for this (and
to propose the services to their individual clients, which, in turn, may go for it or not), or to keep the LSOC model.
Case 3: If the collateral posted by the client is not bankruptcy-remote from the default of the clearing member, so that
its collateral is "commingled" with the collateral posted by the clearing member on its "house" positions, the client is
not seen as having a direct exposure to the CCP, but rather as having a bilateral exposure to the clearing member.
New Regulation Has Strengthened The Quality Of Financial Safeguards
Major CCPs are now generally in a good position to meet the new responsibilities that have been handed to them by
regulators, in our view. We believe that clearinghouses in the EU and in the U.S. in particular have stepped up their
financial safeguards recently--largely thanks to stricter regulation--to minimize losses of non-defaulting clearing
members and ensure market continuity in the case of a member default. For instance, CCPs have generally increased
the resources they make available to absorb clearing risk losses by injecting more of their own capital (or "skin in the
game") within the payment waterfall. We consider substantial "skin in the game" within the waterfall to be a positive
feature because it aligns the interests of the CCP with the interests of its members. With a substantial part of its own
capital at risk, the CCP has an incentive to maintain the robustness of the financial safeguards, which eventually benefit
its members. However, we view too much "skin in the game" in relation of the CCP's total resources as potentially
impairing the CCP's own creditworthiness.
Likewise, in many cases, but not always, guaranty funds now provide CCPs with enough resources to cover losses
arising from the simultaneous default of their largest two clearing members' families under extreme--but
plausible--market conditions (known as "cover 2"). This is required under the new EMIR regulation to be implemented
in the EU next year. Anecdotal evidence suggests that the EMIR reauthorization process being pursued by EU
clearinghouses is also leading to heightened regulatory scrutiny. What's more, these toughened EU and U.S. standards
are in effect being exported because CCPs outside these regions are also having to review and, on occasion, improve
their financial safeguards if they want to be treated as equivalent (i.e., to allow them to be treated by EU/U.S. members
as "qualified" CCPs).
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We believe that differentiation between the robustness of CCPs' financial safeguards could increase in the years to
come because they are increasingly competing with each other for business--in particular to capture the new market of
clearing OTC transactions. Some CCPs may be tempted to relax financial safeguards (for example, by lowering
margins and guaranty fund contributions) to attract customers. Therefore, in our ratings, we analyze the key
differences between CCPs' financial safeguards, particularly with respect to their margining assumptions and guaranty
fund calculations. Generally, CCPs' margining methodology assumes two or three days to liquidate plain vanilla
instruments, such as equity and exchange-traded derivatives, and five days for OTC derivatives. The number of days is
determined by the depth and breadth of the liquidity in the market under stressed scenarios. A CCP's margining level is
determined by both the number of days of coverage (needed to liquidate a position) and the confidence interval
associated with the data used to calculate the margin. Some CCPs, notably in Europe, also provide members with
margin relief for positions that they view as highly correlated. However, there is a risk that the correlations the CCPs
use for margin relief prove wrong when markets stumble and liquidity dries up.
The choices that a CCP makes regarding margining assumptions and guaranty fund calculations give us an indication
of a CCP's risk appetite. For example, assuming a one-day period for liquidating treasury futures may be appropriate in
computing margins in the U.S. given the liquidity of the U.S. market. But it is too lenient, in our view, in most other
markets. Likewise, we take the view that a CCP is more vulnerable to market stress when its guaranty fund's size
covers only the largest clearing member as opposed to the two largest clearing members. Nevertheless, we consider it
positive if a CCP has the right to request their clearing members to replenish the guaranty fund after an event of
default. These assessment powers ensure market continuity, in our view. What matters most in our analysis is the total
resources available to a CCP to cover clearing risk (margins, "skin in the game," guaranty funds, assessment powers)
rather the robustness of any individual components taken in isolation. For example, a best-in-class margining system
may be insufficient if the other resources available to absorb clearing losses are poorly calibrated. For that reason,
assessing the robustness and quality of a clearinghouse's financial safeguards, with an eye to whether business
considerations will tempt them to lower their standards, will remain an essential part of our credit analysis.
Table 1
Clearinghouses Rated By Standard & Poor's
Long-term corporate credit rating Country of operation
SIX Group AG AA- Switzerland
Deutsche Boerse AG AA Germany
NASDAQ OMX Clearing AB A+ Sweden
CME Group Inc. AA- U.S.
LCH.Clearnet Group Ltd. A+ U.K.
IntercontinentalExchange Group Inc. A U.S.
Fixed Income Clearing Corp. AA+ U.S.
Options Clearing Corp. AA+ U.S.
Asigna Compensacion y Liquidacion BBB+ Mexico
BM&FBOVESPA S.A-Bolsa de Valores, Mercadorias e Futuros BBB+ Brazil
Argentina Clearing S.A. raBB+ Argentina
ASX Clear (Futures) Pty Ltd. AA- Australia
National Securities Clearing Corporation AA+ U.S.
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Table 1
Clearinghouses Rated By Standard & Poor's (cont.)
ra--Argentina national scale rating.
Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit
Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its
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affirmation of, a Credit Rating or Rating Outlook.
Additional Contact:
Financial Institutions Ratings Europe; FIG_Europe@standardandpoors.com
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