Sunday, May 5, 2019
This past week, the Commodity Futures Trading Commission (CFTC) released its third clearinghouse supervisory stress test report (see reports for 2016 and 2017). The tests were based upon positions at CME Clearing and LCH Limited, and consisted of: 1) “reverse stress tests of CCP [clearinghouse] resources,” covering futures and options at CME and interest rate swaps at LCH, and 2) an “analysis of stressed liquidation costs,” covering certain interest rate swaps house accounts at LCH .
Among the encouraging findings of these tests were:
The results of the reverse stress test indicate that the two tested CCPs would have sufficient pre-funded resources to cover losses even if all CMs with losses defaulted under certain extreme historic 1-day scenarios.
Results suggest pre-funded resources would have been sufficient to cover extreme but plausible market losses plus liquidation expenses for two house accounts even if the actual liquidation costs were double the amount of the liquidation margin add-on. This analysis, like the reverse stress exercise, did not include assessment powers.
Although encouraging, these results should not be taken as an invitation to complacency in this area. Indeed, as the CFTC’s news release about the tests also notes:
One scenario [of the reverse stress tests] includes market shocks five times the size of those experienced on the day following the Lehman Brothers bankruptcy announcement; this scenario included, for example, price moves as large as 225 bps in swap rates, and 25 percent in stock index futures. These moves likely exceed possible market risk at the CCPs, and thus may be considered implausible. Under this market scenario, only two firms experienced stress losses greater than initial margin at both CCPs concurrently. If both firms defaulted, the combined shortfall would have been slightly greater than pre-funded resources at both CCPs. As the analysis did not include assessment powers, the CCPs would have access to additional resources not considered in the exercise.
Though such scenarios might seem implausible, many working in this area likely did not think the default of an individual trader likely to exhaust two-thirds of the common default fund at Nasdaq Clearing AB in September 2018. A recent paper by researchers at the Bank for International Settlements states that: “The exposures of individual banks [to CCPs] are also large, eg the notional amount of JPMorgan’s OTC derivatives exposures to CCPs is about $30 trillion (Graph 1, right-hand panel).” Additionally, the global clearing mandates are arguably a response to the near collapse of American International Group related to its credit default swap (CDS) activities during the height of the financial crisis in September 2008. Accordingly, additional clearinghouse stress testing, including ones involving CDS, liquidity needs under stress, and interlinkages with the global banking system are still very much needed.