CCP LINES OF DEFENCE
CCPs are of vital systemic importance in the financial markets and have rigorous membership requirements in order to remain stable FMIs for the market. In order to become a member of a CCP, the membership criteria must be met. These differ from each CCP but the general requirements include a variety of factors which include (but not limited to):
- Minimum equity capital requirements (unless the member is a banking institution or regulated by their respective bodies in the country of origin);
- Offer derivatives trading on a commercial basis;
- Operational and administrative expertise;
- Suitable risk-management capabilities;
- Have the technical capacity to connect to the CCP’s trading systems.
However, it’s important to note that the membership criteria are part of the first line of defence in order for the CCP to accept only qualified and commercially proficient members into the network. Memberships are constantly monitored so that ongoing compliance remains valid.
CCPs take equal and opposite positions across all of their exposures in order to have zero market risk. In essence, they align to a ‘matched book’ status where all positions are offset. In order to stem the risks of a potential default of one of the counterparty’s obligations to meet their trade requirement, the CCP collects collateral from clearing members in the form of trade-related exposures (Initial Margin, Variation Margin) and non-trade related exposures (Default Fund contributions).
Initial Margin: Members post collateral to the CCP for every trade to cover the potential losses incurred if that member was to default. This pre-determined amount of collateral funded by the clearing members, is the CCP’s first line of defence. CCPs are therefore able to have extremely high resilience in the form of liquidity and low risk exposure.
Variation Margin: During the course of a trading day, the value of a contract can fluctuate based on market movements. Therefore, the member’s profit and losses are settled on a daily basis (or more frequently, depending on the market changes) in order to stem any large build-up of exposures during the life of the contract. This process is often referred to as mark-to-market. If a member’s contract has increased in value, the CCP is obligated to pay the member the difference, conversely, if the contract declines in value, the member is obligated to pay the difference to the CCP.
For further information, please view our CCP12 report: Primer on Initial Margin
CCP Default Waterfall
All CCPs have a Default Waterfall which provides the process by with financial resources are utilized in order to cover the cost of a defaulting clearing member. If a clearing member defaults, the market risk is shifted to the CCP. In this case the CCP has to follow appropriate pre-defined procedures within the default management process (DMP) in order to prevent any further disruption to its members and the market.
The funds of the Default Waterfall originate from the defaulted clearing member, non-defaulting clearing members and the CCP itself. The CCP’s personal funds are known as the Skin-In-The-Game (“SITG”). (Please see the figure below for a graphical representation of a typical Default Waterfall).
IM: Initial Margin
DF: Default Fund
Both the prefunded resources and non-funded resources are included in the Default Waterfall which are utilised once triggered during the default. The order is specifically relevant, since this incentivises members and the CCP to effectively manage the risks they have exposure to.
The positions of the defaulting member’s clients are then transferred (ported) to non-defaulting members who have the capacity to accept the defaulter’s clients in a process of liquidation (auctioning) of positions that the defaulter holds. Throughout the entire process, the CCP must endeavour to meet its matched book status.
Simmons, M. (2019). Collateral Management: A Guide to Mitigating Counterparty Risk.