One Nick, a Jake and finally a Ross

It was a stunning moment. Ten years to the day of the Lehman’s default, we had another one. This time it “depleted” the mutualised guarantee fund on Nasdaq’s energy CCP. That’s quite something, especially given the amount of effort and change by the clearing industry as a result of EMIR. Did we all get it wrong?

One way to look at margin is as insurance against potential adverse events, there to prevent the clearing member (or in event of a default, the other CCP members) from being exposed to significant loss in these situations.  Another way of thinking about margin is that it reflects the amount of leverage a firm can take.

In the week before the Nasdaq incident, Risk ran a really interesting article where the always-insightful Nick Rustad of JPM gave his views on CCP margin. https://www.risk.net/derivatives/5928621/jp-exec-calls-for-derivative-margin-changes He quite justifiably, in the style of Oliver Twist, asked, “please Sir, can I have some more?” Nick noted that on several occasions the margin at CCP’s was insufficient to cover adverse moves, and this was borne out when back-testing against real examples.

While Nick was talking about Global markets, we now have an example right here in Europe. So are we on the right track? As Jake Pugh mentions in his excellent piece, the default of a clearing member in EMIR will have significant ramifications. Ask him for a copy; it's well worth a read.

Another great piece of analysis from the “streetwiseprofessor”, that among other observations, digs into the impact of ‘fat tails’ on the Nasdaq model.

https://streetwiseprofessor.com/he-blew-up-real-good-and-inflicted-some-collateral-damage-to-boot/

There is a lot of useful analysis out there but when faced with a failure of risk management such as this, I hear what I expect to hear; siren calls for yet more regulation. Indeed, one of the suggestions that appalled me was that risk committee members / risk managers be subject to the equivalent of the senior managers regime and personally liable. I just can’t believe that making Europe’s CCP’s even more conservative, is good for EU inc. or that removing the brightest from risk positions by attaching even more risks is a good plan.

Margin models can’t just cover the value of the likely move, but cover the cost of the unwinding or hedging the position. How much will it cost me to exit this position, especially when everyone knows about it? Who will buy the position? This calibrates increases in margin as position size in more illiquid markets grow. https://www.risk.net/derivatives/5963241/spotlight-on-auction-in-eu114m-nasdaq-clearing-blow-up?

One of the most perverse parts of the prudential regulation was the insistence that collateral provided by clients to clearing members be held on balance sheet (in the leverage ratio) even if segregated in whatever regime the client or CCP is regulated under. See latest in a long line on this topic here: https://www.risk.net/regulation/5925916/exchanges-warn-on-clearing-concentration 

So what’s the solution? Clearly having a conservative risk management (a nod to David Horner at LCH) makes sense https://www.risk.net/risk-management/5957531/lehmans-ghost-how-three-ccps-anchor-models-to-crash but rather than using regulation, lets use capital to solve this issue. If the margin ex ante and post ante are sufficient to cover actual moves in the market (within a small threshold?), then the clearing members can remove the leverage add-on for margin held. If the margin is insufficient the clearing member will have the ability to offer clearing; it will just cost them more. For direct members, capital ratios can adjusted for the same effect. We align interests of members and the clearing house. This is not and should not be read as a siren call for more margin. It's about alignment of interest of all parties to create a stable market for the long term.