Risk Management

1.

Moscow University
Risk Management
Class #13 – Central Counterparty Risk
Management
Lecturer: Dmitry Antoshkin
December/2015
Notice: The concepts, ideas and opinions expressed here do not represent the views of any private institution and are solely those of the lecturers.

2.

Class #13 – CCP Risk Management
1
Clearinghouses and Central Counterparties
2
Central Counterparty Risk Management Framework
3
Calculating CCP Risk
4
Annex
2

3.

Class #13 – CCP Risk Management
1
Clearinghouses and Central Counterparties
2
Central Counterparty Risk Management Framework
3
Calculating CCP Risk
4
Annex
3

4.

Clearinghouses and Central Counterparties
“Post-trade clearing and settlement are sometimes referred to
as the plumbing of the financial system. This term may suggest
that clearing and settlement systems are of secondary
importance. In fact, however, they are more like the central
nervous system of the financial system.”
Michael Moskow, Chicago Federal Reserve
“We allow the City to sleep at night.”
Chris Tupker, LCH.Clearnet
“I’m Winston Wolfe. I solve problems.”
The Wolf, Pulp Fiction
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5.

Clearinghouses and Central Counterparties
Increasing Interest in Central Counterparties After the 2007/2008 Crisis
Successfully Managed to Cope With an Extremely Challenging Environment
Broad Scope of Financial Institutions Affected - Banks, Asset Managers, Insurance Companies
Clearinghouses Faced a Very Difficult Time, But No Relevant Default Occurred in This Sector
Helped to Mitigate the Consequences of Major Defaults
Emblematic Case: Lehman Brothers
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6.

Clearinghouses and Central Counterparties
Clearing, Settlement and Central Counterparty Services
Exchanges, OTC Markets
Trading
Post-Trading
Clearing and Central Counterparty Services
Clearing Transactions
Credit Risk Substitution
Default Management
CSDs, Banks
6

7.

Clearinghouses and Central Counterparties
Credit Risk Substitution
Original Buyer
Original Seller
Credit Risk: Seller
Credit Risk: Buyer
Substitution
Original Buyer
Central Counterparty (CCP)
Credit Risk: CCP
Original Seller
Credit Risk: CCP
The Central Counterparty Becomes the Buyer to Every Seller and the Seller to Every Buyer
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8.

Clearinghouses and Central Counterparties
Default Management
Original Buyer
Original Seller
Central Counterparty (CCP)
Credit Risk: CCP
Credit Risk: CCP
Default Management
Procedures
New Buyer
Credit Risk: CCP
Stressed Markets
Uncertainty
Time Constraints
Kitchen
Restaurant
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9.

Clearinghouses and Central Counterparties
Default Management
Default Management Procedures
Important Risk
Financial Losses Due to Adverse Market Conditions
Example
Original Seller Sold 1M USD at 55,00 RUB/USD
Original Buyer Defaults – Does Not Deliver 55M RUB
Now Market is 50,00 RUB/USD
That Mean That a New Buyer Would Pay Only 50M RUB for 1M USD
Still, The Original Seller is Entitled to Receive 55M RUB in Exchange for 1M USD
Who’s Going to Pay for the Extra 5M RUB?
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10.

Clearinghouses and Central Counterparties
Loss Sharing Mechanisms in Central Counterparties
Defaulter Pays Model
In the case of a default, losses must be absorbed by the defaulting
participant alone. This typically entails having cash and securities posted as
collateral prior to the default event (i.e. margin requirements).
Survivors Pay Model
In the case of a default, losses must be absorbed by the “surviving”
participants (i.e. non-defaulters). This typically entails creating a pool of
mutualized resources (i.e. clearing fund) that can be accessed in the event of
a default.
Third Party Pays Model
In the case of a default, losses must be absorbed by a third party (i.e. nonparticipant). This typically entails having a guarantor (e.g. the CCP itself,
insurance company) that puts its own capital at risk in exchange for a –
implicit or explicit – premium.
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11.

Clearinghouses and Central Counterparties
Hybrid (Multi-Layered) Mechanisms Tend to be More Efficient and are the Industry’s Norm
TP
Activation
CCP Capital
SP
Risk Waterfall
Clearing Fund
DP
Margin Requirements
The Size of Each Layer Usually Corresponds to a Given Confidence Level
100.00%
Level of
Confidence
99.99%
99.95%
99.50%
Margin Requirements
Clearing Fund
CCP
Capital
0.00%
Activation
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12.

Clearinghouses and Central Counterparties
Systemic Risk – Avoiding Contagion, Gridlocks and Complexity
…
CCP
Default Management
Process
Default Management
Process (?)
No CCP
With CCP
= Default
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13.

Clearinghouses and Central Counterparties
Homogeneous Credit Risk – Main Benefits for the Trading Activity
Equal Opportunities for Different Types of Participants
The Way They Are
The Way They Perceive Themselves
Superior Price Formation
Absence of Credit Spreads
Dynamic Electronic Trading Environment
Anonymous Trading
13

14.

Class #13 – CCP Risk Management
1
Clearinghouses and Central Counterparties
2
Central Counterparty Risk Management Framework
3
Calculating CCP Risk
4
Annex
14

15.

CCP Risk Management Framework
Central Counterparty Risk Management Framework
Encompasses All Risk Dimensions Present in Day-to-Day Activities of a Clearinghouse
Legal Risk
Operational Risk
Deterrence
Minimizes the probability of adverse events.
Credit Risk
Resiliency
Adverse events have limited, well known, consequences.
Market Risk
Continuity
Smooth operation, even under adverse conditions.
Liquidity Risk
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16.

CCP Risk Management Framework
Legal Risk
Main Dangers
Disputes Concerning Services and Procedures
Basic Toolkit
Sound Legal Framework
Settlement Unwind
Netting
Litigation re Default Procedures
Certainty and Finality
Collateral Seizure
Collateral Protection
Adherence to Clearinghouse Rules and Procedures
Well Structured Contracts
Clarity re Responsibilities and/or Potential Liabilities
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17.

CCP Risk Management Framework
Operational Risk
Main Dangers
Basic Toolkit
IT Disruptions
High Availability IT Architecture
Human Error, Fraud
Internal Audits
Unavailability of Service Providers
Adequate Staffing
Natural Catastrophes
Business Continuity Plans
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18.

CCP Risk Management Framework
Credit Risk
Main Dangers
Basic Toolkit
Default of a Participant
Well Structured Default Procedures
Default of a Financial Services Provider
Admission Criteria
Declining Credit Quality/Default of an Issuer of
Collateral
Conservative Investment Policy
Declining Credit Quality/Default of an Issuer of
Investment Assets (Investment Portfolio)
Continuous, Thorough Credit Assessment
Participants
Financial Services Providers
Issuers – Collateral and Investments
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19.

CCP Risk Management Framework
Market Risk
Main Dangers
Closeout Process Given a Participant Default
Basic Toolkit
Robust Safeguard Structure
Declining Collateral Values due to Adverse Market
Movements
Margin Requirements
Declining Investment Values due to Adverse Market
Movements (Investment Portfolio)
Clearing Funds
CCP Capital
Comprehensive, Continuous Risk Monitoring Process
Collateral Eligibility Criteria, MtM and Haircutting
Conservative Investment Policy, MtM
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20.

CCP Risk Management Framework
Liquidity Risk
Main Dangers
Basic Toolkit
Closeout Process Given a Participant Default
Liquidity Facilities
Liquidity Constraints in the Investment Portfolio
Concentration Limits and/or Add-Ons
Participant Positions
Collateral
Investments
Comprehensive, Continuous Risk Monitoring Process
20

21.

Class #13 – CCP Risk Management
1
Clearinghouses and Central Counterparties
2
Central Counterparty Risk Management Framework
3
Calculating CCP Risk
4
Annex
21

22.

Calculating CCP Risk
The Risk Management Problem of a Central Counterparty
In The Absence of a Default, The CCP is Not Exposed to Market Risk
Zero Net Position
Buyer to Every Seller, Seller to Every Buyer
In The Case of a Default
Closeout Procedures
Adverse Market Environment
Financial Losses
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23.

Calculating CCP Risk
The Risk Management Problem of a Central Counterparty
Full Control the Portfolio Composition/Risk Profile
Risk Management in
Banks and Investment
Funds
No Pressing Need to Close Out Positions
Virtually no Limitations Concerning Hedging Procedures
Mark-to-Market Risk (i.e. Losses in Portfolio Value)
Very Limited Control the Portfolio Composition/Risk Profile
Risk Management in
Central
Counterparties
Positions Have to be Closed Out in a Short Period
Hedging Procedures can be Limited
Closeout Risk (i.e. Losses Inherent to the Closeout Process)
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24.

Calculating CCP Risk
The Risk Management Problem of a Central Counterparty
When Modeling the Risk Management Problem Faced by a Clearinghouse, one Must Consider, in a Joint Fashion, the Evolution
of Market Variables (Prices and Rates) and the Portfolio Composition, Respecting a set of Important Restrictions Imposed by
the Characteristics of Each Asset Under Consideration
P&L Calculation
Dynamic Process With Frictions
Closeout Risk
Calculation
t+0
t+1
t+2
t+3
t+4
...
t+N
Open Position (Original Portfolio)
Ordinary, VaR-Like Models, Tend to Focus on the Potential Changes in Value (MtM) of a Static Portfolio, and This can be
Regarded as Fairly Good Approximation to Closeout Risk in the Case of Highly Homogeneous Portfolios. In the Case of Highly
Heterogeneous Portfolios (Multi Asset-Class and Multi Market), However, This is far from Acceptable.
P&L Calculation
Static Process Without Frictions
MtM Risk Calculation
(VaR-Like Models)
t+0
Implied Closeout Scenario: All Positions
are to be Settled at the Same Time
Without any Frictions and With Fully
Coinciding Cash Flows
t+M
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25.

Class #13 – CCP Risk Management
1
Clearinghouses and Central Counterparties
2
Central Counterparty Risk Management Framework
3
Calculating CCP Risk
4
Annex
25

26.

Annex
Useful References
‒ Principles for Financial Market Infrastructures, CPMI-IOSCO, (2012);
‒ Modelling Risk in Central Counterparty Clearing Houses – A Review, Bank of England, (2002);
‒ The Economics of Central Clearing: Theory and Practice, Pirrong, C., ISDA, (2011).
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27.

Vassily Vassilyevich Kandinsky, Autumn in Bavaria, 1908