What happens if and when one of the large CCPs runs into a major default by one or more of its members? George Bollenbacher of OCREUS Group’s sister US firm Capital Markets Advisors, takes a deep dive into the risks and regulatory requirements.

The recent publication by the Financial Stability Board (FSB) of its “Guidance on Central Counterparty Resolution and Resolution Planning” refocuses attention on an issue that has been lurking under the surface for some time: What happens if and when one of the large CCPs runs into a major default by one or more of its members? It turns out that a lot has been written on this subject, but, if the waters are already murky, stirring things up again may only make matters worse. So we need to take a deep breath and dive into this scary subject.

Who Said What


In July 2016 the CFTC issued Letter 16-61, covering recovery and wind-down plans for derivatives clearing organisations (DCOs). The letter points out that CFTC Reg 39.39 requires each DCO to “identify scenarios that may potentially prevent [the DCO] from being able to meet its obligations, provide its critical operations and services as a going concern and assess the effectiveness of a range of options for recovery,” and “(1) to identify the range of specific scenarios that may adversely impact the DCO and (2) to assess fully their respective impacts on the DCO, the DCO’s clearing members, and other relevant stakeholders.”

After reviewing various DOCs’ plans, the CFTC notes that, “A DCO need only identify and address the types of scenarios referenced in Regulation 39.39(c)(1), not each market scenario that would result in losses. Thus, a DCO is not expected to analyse the number of specific scenarios or events that may be necessary for stress testing.” Why the CFTC would take that position is beyond me. It does, however, lay out a nonexclusive list of scenarios:

a. a settlement bank failure;
b. a custodian bank failure;
c. scenarios resulting from investment risk;
d. poor business results;
e. the financial effects of cybersecurity events;
f. internal fraud, external fraud, and/or other actions of criminals or public enemies;
g. legal liability not specific to the DCO’s business as a DCO; and
h. losses resulting from interconnections and interdependencies among the DCO and its parent, affiliates, and/or internal or external service providers.”

Notably missing from this list is a high-risk strategy undertaken by a market participant, cleared through a number of FCMs that are not aware of the full exposure of the participant. The requirement does include, among other things:

“a. description of the scenario;
b. the events that are likely to trigger the scenario;
c. the DCO’s process for monitoring for such events;
d. the market conditions, operational and financial difficulties and other relevant circumstances that are likely to result from the scenario.”

So it would be useful if we could review the recovery and resolution plans the DCOs have prepared in response to Reg 39.39. However, according to the CFTC, neither the regulation nor the agency requires such plans be made publicly available, so we are left guessing as to what they say.


The FSB takes what appears to be a more practical approach, indicating, for example, that:

“CCP resolution should seek to:

(i) maintain market and public confidence while minimising contagion to the CCP’s participants, any entities affiliated to the CCP and to other FMIs [Financial Market Infrastructures];
(ii) avoid any disruption in the operation of links between the CCP in resolution and other FMIs where such disruptions would have a material negative effect on financial stability or the functioning of markets; and
(iii) maintain continuous access by participants to securities or cash collateral posted to and held by the CCP in accordance with its rules and that is owed to such participants.”

Then the document takes up the contentious question of contractual obligations to and by the CCP. It would give the resolution authority …

“the power to enforce any outstanding contractual rights and obligations of the CCP, including any existing and outstanding contractual obligations of the CCP’s participants to meet cash calls or make further contributions to a default fund, or any other rules and arrangements of the CCP for the allocation of both default and non-default losses (including for the repayment of liquidity providers) where they have not been already applied exhaustively by the CCP prior to resolution.”

That looks equivalent to the powers of a bankruptcy court in the US.

Then it looks at the status of derivative contracts specifically, and says, “The resolution authority should only consider applying a partial tear up if market-based actions to return to a matched book (e.g., auctions or direct liquidation of positions into the market) have failed or are expected to fail, or would likely result in losses that exceed the prefunded and committed financial resources that are available under the CCP’s rules and arrangements to cover those losses, or would otherwise compromise financial stability,” and envisions full tear-ups as a last resort.

The Worst-Case Scenario

While no one wants to talk about a worst-case scenario, we have to do that. We can begin with a market participant that has taken some wrong way positions, such as a hedge fund, a dealer, or a corporation. Faced with a loss and a backlash, the participant decides to make a hail-Mary bet in the derivatives market. The participant either already has or proceeds to open clearing accounts with multiple FCMs, in multiple jurisdictions, at more than one CCP, and loads up all the accounts with the same position. If the accounts are all omnibus, and the FCMs do not share their customer information with other FCMs, none of the FCMs nor the CCPs know the full extent of the participant’s exposure.

Now the market moves decisively against the hail-Mary position. Faced with massive margin calls, the participant peremptorily files bankruptcy in its home jurisdiction, possibly even before the FCMs actually make the margin calls. Only after the FCMs follow up on the missed calls do they find out the size of the total exposure, and only then do the CCPs begin to understand that the multiple positions they are carrying are all for the same party.

What happens then is a cascade of rumours and bad news, prompting FCM customers to attempt to withdraw any free cash balances, potentially crippling the FCMs. Because nobody knows who actually owns all the positions at the CCPs, everyone assumes the worst. The rumours and news also accentuate the volatility of the markets, increasing the margin calls, and possibly precipitating additional defaults. Only when the regulators step into the markets, perhaps declaring a trading halt, and identify all the end participants in all the positions, would sanity return to the markets. And then the blaming would begin.

An Ounce of Prevention

In the aftermath of such an event, the immediate outcry would be, “How could this have happened?” The simple answer is opacity. Once the participant established the positions in opaque silos, nothing could be done to prevent the meltdown. Any recovery and resolution program at any CCP would be overwhelmed by the market-wide panic.

The opposite of opacity is, of course, transparency, but transparency is often hard to come by in the markets, and clearing is no exception. Neither CCPs nor FCMs are anxious, or even willing, to give out the identities of customers/position holders or the sizes of their positions – except that they already give it to someone else, for US futures and options. Under Part 16 of the CFTC’s regulations, exchanges must provide the Commission with confidential information on the aggregate positions and trading activity for each of their clearing members.

Specifically, “Each reporting market shall submit to the Commission … a report for each business day, showing for each clearing member, by proprietary and customer account, [position and owner] information separately for futures by commodity and by future, and, for options, by underlying futures contract (for options on futures contracts) or by underlying commodity (for other commodity options), and by put, by call, by expiration date and by strike price.” In this case, however, the reporting is being done by the exchange, not the FCM or CCP.

On its face, there is no reason why similar information about cleared OTC derivatives positions couldn’t be reported confidentially to regulators in the various jurisdictions, and no reason they couldn’t pool their confidential information to get a consolidated view of cleared positions in pretty close to real time. Of course, the global reporting of trades in OTC derivatives has been pretty much a failure, with every regulator complaining that it can’t make heads or tails of what it is seeing. However, since we are focused here on cleared instruments, we should hope that the reported information would be somewhat better than the market as a whole.

There doesn’t appear to be any better way to enhance the transparency of cleared positions, so this appears to be the best option for clearing the fog.

See full and other articles by George published on the Tabb Forum here

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