LCH.RepoClear adds an extra layer to the repo risk waterfall. Is it gilding the lily?

LCH.RepoClear has added a extra layer to their risk waterfall. We wonder if allocating losses among the clearing members, should all other resources be exhausted, isn’t a bit of gilding the lily.

From LCH’s January 14, 2013 press release, “…In the event of a RepoClear member default, where exceptional losses have been incurred in excess of the financial resources available, loss allocation ensures the ongoing operation of other LCH.Clearnet clearing services by introducing a further level of protection to the default waterfall…” Not a lot of detail there, but I think we get the gist. We wonder if LCH adopted this to fall in line with the risk waterfalls of other clearing houses?

One questions the value of adding this extra cushion that kicks in when all other assets are gone. In the event of a one-off event that impacts a single clearing member, without any contagion to other market participants, we suppose that the risk sharing is creates a workable private bailout. It is just that in the connected inter-dependent world we live in, is the scenario plausible? This is not to say the LCH.RepoClear’s risk management isn’t first rate already. After all, they survived unwinding MF Global’s repo portfolio without a hitch.

Speaking of MF Global, we presume that the ability to raise haircuts when the underlying collateral becomes more volatile or counterparty a bit dodgy – what has been referred to as “bad boy collateral” – remains in place. While it is a difficult decision to invoke this provision since it can be a death knell for an institution’s liquidity, the fact that it is there means that the clearinghouse can proactively manage risk. We wrote about this back in December, 2011 “Has MF Global Revealed a Fatal Flaw in CCP Margin Procedures? An Analysis of MF Global’s Margin Failure”. It is SOP for futures exchanges to change margin when market conditions change (or at least have the ability to), but for repo traders doing term trades, the mindset has always been once executed, the only collateral risk to manage are daily margin calls. The trick is to have repo agreements that are symmetrical with the LCH agreements, otherwise there can be a nasty mismatch risk.

A link to our Dec. 2011 post is here.

A link to the LCH press release is here.

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