Group Risk Management
Managing and mitigating risk at LCH
Risk management lies at the heart of everything that we do at LCH. As a private company with a public mission to safeguard financial markets, our overriding objective is to provide resilient and robust central counterparty services for our Clearing Members and their clients, even in the most turbulent of market conditions.
Our risk management framework has proven itself capable time and again, and seeks to protect our members through the worst of the turmoil markets have experienced in recent years.
We also give our Clearing Members and their clients the autonomy to customise the level of protection their cleared trades and collateral receive, from fully comingled positions to maximise efficiencies, to wholly segregated accounts.
This is what it means to be The Markets’ Partner.
How does LCH distinguish itself from its competitors in the risk management landscape?
At a high level, all clearing houses employ similar risk mitigation procedures, but we pride ourselves on going the extra mile to give our Clearing Members and their clients an exceptional level of protection. This is The LCH Difference.
Below you can see how The LCH Difference manifests itself and where our best-in-class risk management principles set us apart from other central counterparties (CCPs).
Risk governance is the foundation of good risk management. Governance arrangements define roles and responsibilities that promote the safety and efficiency of the CCP.
The LCH Difference: Our risk management framework is based on the Three Lines of Defence Model (“3LoD”) – a recognised best practice for effective risk management that cultivates objectivity within the organisation through segregation of roles.
Under the 3LoD model, the application of the risk policies is primarily undertaken by the business functions as the first line of defence.
The risk management team forms the second line of defence to provide independent assurance and monitoring of risk exposures arising from the various clearing activities against the LCH Board’s standards.
The third line of defence is internal audit, whose role is to review risk management practices and provide assurance to the Board.
A chart of the Risk Governance Committee structure is available to view here.
Risk management begins even before an entity is admitted to the clearing house as a member. All prospective members are scrutinised to verify they possess both the financial resources and operational capabilities to meet CCP risk management requirements.
The LCH Difference: We adhere to stringent eligibility requirements for entrants to our clearing services. Candidates for Clearing Membership must demonstrate that they have the necessary competency to appropriately value, risk manage and default manage cleared trades for the asset classes they wish to clear.
Clearing houses collect initial margin from members to cover losses incurred in the event of a default. Under UK and EU legislations, that would be at a 99% and 99.5% confidence interval for listed and OTC derivatives, respectively. Under US legislation, the minimum confidence level is 99%.
The LCH Difference: Certain CCPs calculate initial margin only to the regulatory minimum. We calculate our initial margin requirements to an enhanced 99.7% confidence interval. Our proprietary initial margin models feature a coherent risk measure, standardised returns, and long look back periods of up to 10 years where data is available. These model characteristics aim to ensure we achieve an optimal balance between stable, conservative margins without undesirable procyclical behaviours.
CCPs collect variation margin from all clearing participants to account for changes in the mark-to-market value of cleared trades on a daily basis.
The LCH Difference: We make multiple intraday margin calls to more closely track changes in the values of cleared positions throughout the trading day. In a volatile market, calling for additional variation margin through the day minimises risk to counterparties that would otherwise be exposed to gapping prices from one day to the next. In OTC clearing services, we conduct real-time intraday risk monitoring to ensure incremental risk due to new trades is collateralised prior to acceptance/novation.
In the event of a Clearing Member default, the collateral and default fund contributions of the defaulting Clearing Member are utilised first, followed by the CCP's own funds (“skin-in-the-game”) and then by the default fund contributions of non-defaulting Clearing Members.
The LCH Difference: Our “defaulter-pays” principle results in higher collateralisation requirements. This bolsters the available margin from the defaulting Clearing Member that can be used for default management and lessens the probability that resources from non-defaulting Clearing Members are exposed. In addition, each clearing service has its own dedicated default fund waterfall to prevent contagion across asset classes. We have also set aside 25% of our regulatory capital requirement as “skin-in-the-game,” which provides strong incentives for our management to control risk exposure and prevent perceptions of moral hazards.
CCPs conduct periodic fire drill tests to confirm readiness to manage the default of a Clearing Member.
The LCH Difference: In addition to all clearing services conducting regular fire drills, we run an annual group-wide fire drill which simulates the default of a Clearing Member that has risk exposures across all of LCH’s clearing services. These drills enable us to continually validate the operational readiness of CCP staff, systems and procedures, Clearing Members and intermediaries. All layers in the default waterfall, including assessments and loss allocations, are tested.
Operational risk is the risk of loss arising through failures associated with personnel, processes or systems or from external events. It is inherent in every business organisation.
The LCH Difference: We have a framework, supported by tailored enterprise-wide software, to systematically identify, assess, monitor and manage operational risks. This is achieved through self assessment of risks and controls using a comprehensive Risk and Control Library, the analysis of loss events and the tracking of key risk indicators. Operational risk awareness is embedded within our corporate culture. An independent department performs second line operational risk management, validating the self-assessments of risks and controls and reporting on operational risk to senior management as well as to the CCP Boards.
As an important part of financial market infrastructure, CCPs have plans to provide continuity and timely recovery of its business operations in the event of a major incident or crisis, which impacts, or has potential to impact, business operations.
The LCH Difference: Our Business Continuity policy sets a recovery time objective of two hours for all critical services; this recovery time objective is in place regardless of the scale of the incident or disruption. A Disaster Recovery Plan is also in place which describes the technical steps that are required in order to affect a timely recovery. Our comprehensive contingency plans, work area recovery facilities, and data centres are regularly tested to ensure that they meet our stringent internal standards.
The result of holding ourselves to higher risk management standards is a strong, robust, and resilient clearing house that is well-positioned to carry out our mission of enhancing financial markets’ stability while minimising risk for our participants.
This is The LCH Difference.
The LCH Group has two central counterparties (CCPs): LCH Ltd in the UK and LCH SA in France.
While LCH has a harmonised approach to risk management, there are some differences in the details due to the legal and regulatory requirements governing both entities in locations and the different asset classes that they clear.
By clicking on the two links below, you will be able to access more detailed information about the risk management frameworks, margin methodologies and models, default management and risk governance at both of our CCPs.
LCH has managed 9 member defaults and, in all cases, losses were within the initial margin held:
- VTB Capital PLC (2022)
- Maple Bank GMBH (2016)
- Cyprus Popular Bank Co Ltd (2013)
- MF Global UK Ltd (2011)
- Lehman Brothers (2008)
- Griffin (1998)
- Barings (1995)
- Woodhouse, Drake and Carey (1991)
- Drexel Burnham Lambert (1990)
LCH’s Default Funds, Clearing Members and cleared markets were not impacted by any of these defaults.
Below you can find a selection of white papers LCH has recently published providing insight and analysis on clearing risk management issues.