We are a market leader in centrally cleared OTC interest rate swap markets.
As part of the Central Counterparty service offering, SwapClear’s core business is to provide reassurance regarding the performance of all the contracts it clears, especially in the case of a member default.
In order to be confident that it can maintain the safety and stability of Clearing Members and clients, the service has built a framework of safeguards, underpinned by state-of-the-art risk models.
These various layers of protection work in concert to ensure that we have adequate financial resources to fulfil these obligations in all circumstances - most importantly, to protect cleared trades at our clearing house and the collateral posted against them.
Risk management is at the core of everything we do at here at SwapClear.
As our first line of defence, SwapClear sets stringent and transparent eligibility requirements for prospective Clearing Members. In order to be considered at the clearing house, a candidate for membership must demonstrate that they have the necessary expertise and competency to appropriately import, value, and participate in auctions for a defaulted portfolio.
When new Members begin clearing trades, LCH collects initial margin from them to cover potential losses in the event of a default. We calculate initial margin using LCH’s PAIRS (Portfolio Approach to Interest Rate Scenarios) methodology, which uses ten years of historical market data to estimate the potential loss distribution. We also apply margin add-ons covering credit risk and liquidity risk where a particular Member’s inherent risk exposure is not captured within the PAIRS model.
In addition to initial margin, we also collect daily and intraday variation margin from all counterparties to account for changes in the mark-to-market value and margin payments will be processed by LCH.
By collecting variation margin, we ensure that all our Members are current on all obligations which prevent default scenarios where Member losses could have accumulated over a prolonged period of time.
In the event of a Clearing Member default, these pre-emptive safeguards dramatically limit the impact arising from the default. The defaulted portfolio is hedged to reduce its risk, which in turn makes SwapClear’s task of auctioning and porting trades facing the defaulted member to healthy counterparties vastly easier.
Following the Clearing Member default, our default waterfall model dictates that the Clearing Member’s posted margin and default fund contributions are the first resources to be consumed. Only after these resources are exhausted across all services and LCH own ‘skin-in-the-game’ is consumed would non-defaulting Clearing Members begin to experience losses.
LCH maintains a rigorous default management process.
LCH has a proven track record of handling defaults, managing the Lehman default ($9 trillion portfolio of 66,390 trades) and using only 35% of Lehman’s Initial Margin across all assets held at LCH.
Our default management process follows three steps to reduce the risk of the defaulted firm’s outstanding positions without impacting other non-defaulting Clearing Members:
Risk neutralisation & client porting
After a Clearing Member default, LCH immediately begins porting non-defaulting clients to non-defaulting Clearing Members. Alongside this, we hedge the defaulter’s trade portfolio with the assistance of our Default Management Group (DMG), senior executives with appropriate skills and expertise from its clearing members and certain other members as the DMG considers appropriate, that are seconded to LCH in the event of default.
Once the risk of the portfolio is substantially reduced by the DMG, LCH splits the defaulter’s portfolio by product and currency. An auction is then conducted for each portfolio. The ability to receive and price an auctioned portfolio is one of the criteria we verify prior to granting firms membership to SwapClear.
In the event that losses are greater than the financial resources of the defaulting member and of LCH, the funded Default Fund contributions of non-defaulting SwapClear members are used.
Losses arising from variation margin and hedges are attributed pro-rata, while losses arising from auctions are attributed based upon bidding behaviour in the auction.
LCH’s default waterfall establishes the order in which the financial resources of a defaulted Clearing Member, non-defaulting Clearing Members and the resources of LCH itself are consumed during the resolution of a default.
A defaulting Clearing Member’s posted margin is the first asset to be consumed in managing the default, followed by the defaulter’s contribution to default funds.
If these assets prove insufficient to resolve the default, LCH’s own capital is next in line for losses. It is only after all of these resources are exhausted that default fund contributions from non-defaulting Clearing Members are used to close out the portfolio.
In the extreme event that all waterfall resources are consumed and defaulted positions have not been fully auctioned, an additional safety net will be triggered allowing the service to continue. This is the Loss Allocation stage, which sees Variation Margin Gains Haircutting (VMGH) applied to accounts that have made profits since the point of default.
The default waterfall structure can be viewed here.