LCH.Clearnet has just published “Stress This House, A Framework for the Standardised Stress Testing of CCPs”, an analysis of risk management at CCPs. It is worth a look. This is part 1 of a two-part post.
There is a bit of a pissing match going on between the users of central counterparties (including asset managers, clearing members, etc.) and CCPs about how to best fortify the risk waterfall. More default fund and margin? More capital from the CCP itself? Both? Each side has taken the view that suits their own interests and has gone on a PR campaign. This publication is LCH.Clearnet weighing in. We covered this in depth in our February 2015 research report, “CCP Recovery and Resolution Plans: Players, Regulations and Ideas“.
On March 11th, the Committee on Payments and Market Infrastructures (CPMI) and the International Organisation of Securities Commissions (IOSCO) began a review of CCP stress testing. From the BIS press release:
“…The systemic importance of CCPs is growing substantially, not least due to the drive for standardised OTC derivatives to be centrally cleared. The CPMI and IOSCO therefore believe that a review of CCP stress testing is timely in order to identify how the relevant PFMI standards are being implemented and whether additional guidance in this area is needed. CCPs, clearing participants and other relevant stakeholders will be consulted in the course of the review…”
From the LCH.Clearnet paper:
“…CCPs regularly stress test their default management processes; however, as yet there is no global standard for a stress testing framework…This paper details LCH.Clearnet’s proposed stress testing framework that will inform and assist the review process being undertaken by CPMI-IOSCO. A standardised stress testing methodology will help improve transparency around CCP risk management. It will allow clearing members and regulators to compare different CCPs on a relative basis, to evaluate the strength and resiliency of clearing houses and to assess the extent to which a CCP’s pre-funded resources (default fund contributions and CCP skin in the game) would be consumed under a uniform set of stresses. In addition, it attempts to place CCPs on a level playing field regardless of confidence levels used to calculate margin, holding and methodology for sizing default funds, etc.…”
There are 5 basic elements to the LCH.Clearnet approach (from the report):
Element 1: The segregation of assets appropriate to eliminate masking effects within portfolios.
Element 2: The construction of a standardised stress testing framework using:
- Historical scenarios
- Hypothetical scenarios
- De-correlation stresses within the asset class
Element 3: Combining the results of the stress testing exercises across the three types of standardised stress scenarios.
Element 4: Stress testing the cover 2 standard to calculate the maximum number of members that could default simultaneously in each scenario without recourse to the CCP’s pre-funded resources.
Element 5: Evaluating the risk of successfully auctioning defaulted clearing members’ portfolio of trades under each cover 2 scenario without exhausting the pre-funded default fund of the CCP.
Without a harmonized approach to stress testing, LCH.Clearnet says it is harder to assess the “relative resilience” of each CCP. Different rules get different results although the optics may give no clue that it may be apples to oranges. Kind of reminds us of bank RWA calculations.
Going back to the Principles for Financial Market Infrastructures (PFMI) published by the CPSS and IOSCO in April 2012, CCPs were required to collect initial margin based on a 99% confidence level and to “…conduct rigorous stress testing to determine the financial resources necessary to manage both credit and liquidity risk, in a variety of extreme but plausible market conditions…” but “…did not propose a standardised testing regime that would permit like-for-like comparisons of the resiliency of one CCP versus another…”
In or second post, we will take a closer look at the 5 basic elements and how they flow through to LCH.Clearnet’s stress testing.