How Does Joint Clearing Membership Amplify Systemic Risk between CCPs? ▴ Question

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The Interconnected Fate of Central Counterparties

Following the 2008 financial crisis, central clearing for derivatives became a cornerstone of regulatory reform, designed to mitigate counterparty risk by positioning a central counterparty (CCP) between the buyer and seller of a derivative contract. This structure was intended to create a more resilient financial system. However, the reality of the modern derivatives market is one of a small number of CCPs, linked together by a limited group of large banks that are members of multiple CCPs. This joint clearing membership creates a complex web of interconnections that can, under certain circumstances, amplify systemic risk rather than reduce it.

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A Network of Shared Vulnerabilities

The interconnectedness of CCPs through joint clearing members creates a network effect where stress at one CCP can be transmitted to others. This is because a default by a joint clearing member at one CCP can trigger a cascade of events that affect other CCPs where that member also has positions. The default management process of a CCP, known as the “default waterfall,” is designed to absorb losses in a specific order, starting with the defaulting member’s initial margin and default fund contributions. However, a simultaneous default by a joint clearing member at multiple CCPs can lead to losses that exceed the resources of each individual CCP, potentially leading to a wider systemic crisis.

The concentration of clearing activity among a small number of large banks creates a situation where the failure of a single joint clearing member could have far-reaching consequences for the entire financial system.

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The Role of Contagion Channels

Two primary contagion channels can amplify systemic risk in a multi-CCP environment with joint clearing members:

Fire-sale channel ▴ When a joint clearing member defaults, the CCPs where it holds positions are forced to liquidate the collateral posted as initial margin. If the collateral is illiquid, this forced liquidation can drive down prices, leading to further losses and potentially triggering other defaults. This is particularly dangerous when multiple CCPs are liquidating the same type of collateral simultaneously.
Variation margin gains haircutting (VMGH) ▴ VMGH is a tool that allows a CCP to curtail payments to surviving clearing members in the event of a default. While this can help to stabilize a single CCP, it can also create spillover effects on other CCPs by reducing the liquidity available to surviving members, potentially causing them to default on their obligations at other CCPs.

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Strategy

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Deconstructing the Default Waterfall

The default waterfall is the primary mechanism through which a CCP manages the default of a clearing member. It is a tiered approach to loss absorption, with each layer representing a different source of funds. Understanding how joint clearing membership affects each layer of the waterfall is critical to appreciating the potential for systemic risk amplification.

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The Layers of the Default Waterfall

A typical default waterfall consists of the following layers:

Defaulting member’s resources ▴ This includes the initial margin and default fund contributions of the defaulting member.
CCP’s “skin-in-the-game” ▴ A portion of the CCP’s own capital that is used to absorb losses after the defaulting member’s resources have been exhausted.
Surviving members’ default fund contributions ▴ The contributions of the non-defaulting members to the CCP’s default fund.
Additional contributions from surviving members ▴ In some cases, surviving members may be required to make additional contributions to the default fund.

Joint clearing membership can impact both the resources of defaulting members and the ability of surviving members to contribute to the default fund, creating a more fragile system.

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The Perils of Procyclicality

One of the key challenges in managing systemic risk in a multi-CCP environment is the procyclicality of margin requirements. During periods of market stress, volatility increases, leading CCPs to increase their margin requirements. This can create a vicious cycle where higher margin calls lead to further selling pressure, which in turn leads to higher volatility and even higher margin calls. This dynamic can be exacerbated by joint clearing membership, as a single firm may face margin calls from multiple CCPs simultaneously, increasing the likelihood of default.

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Comparing Clearing Methods

The way in which multiple derivatives are cleared can have a significant impact on systemic risk. A study comparing joint clearing in the same CCP with separate clearing in different CCPs found that the former is associated with lower systemic risk. This is because joint clearing allows for the netting of positions across different derivatives, which can reduce the overall level of risk in the system.

Comparison of Clearing Methods
Clearing Method	Systemic Risk	Rationale
Joint clearing in the same CCP	Lower	Allows for netting of positions across different derivatives, reducing overall risk.
Separate clearing in different CCPs	Higher	Increases the potential for contagion between CCPs through joint clearing members.

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Execution

Enhancing CCP Stress-Testing

The current standard for CCP stress-testing, known as “Cover 2,” requires CCPs to be able to withstand the default of their two largest clearing members. However, this standard does not adequately account for the higher-order effects of interconnectedness through shared clearing membership. A more comprehensive approach to stress-testing is needed, one that considers the full network of CCPs and shared clearing members.

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A Network-Based Approach to Stress-Testing

A network-based approach to stress-testing would involve the following steps:

Mapping the network ▴ The first step is to map the network of CCPs and joint clearing members, identifying the key nodes and connections.
Simulating defaults ▴ The next step is to simulate the default of different clearing members, both individually and in combination, to assess the potential for contagion.
Quantifying shortfalls ▴ The final step is to quantify the potential payment shortfalls at each CCP under different default scenarios.

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The Importance of Liquidity Risk Management

Central clearing transforms counterparty risk into liquidity risk. This is because margin calls transform accounting losses into realized losses, which can deplete the liquidity buffers of clearing members. Therefore, it is essential that CCPs and clearing members have robust liquidity risk management frameworks in place. This includes maintaining adequate liquidity reserves and conducting regular liquidity stress tests.

The failure to properly manage liquidity risk can have severe consequences for financial stability, particularly in a multi-CCP environment with joint clearing members.

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Policy Implications

The potential for joint clearing membership to amplify systemic risk has a number of important policy implications:

Policy Implications of Joint Clearing Membership
Policy Area	Recommendation
CCP stress-testing	Adopt a network-based approach that accounts for the interconnectedness of CCPs and joint clearing members.
Liquidity risk management	Strengthen liquidity risk management frameworks for both CCPs and clearing members.
Data sharing	Improve data sharing between CCPs and regulators to provide a more complete picture of systemic risk.

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References

Aldasoro, Iñaki, and Luitgard A. M. Veraart. “Systemic risk in markets with multiple central counterparties.” Journal of Financial Stability, vol. 63, 2022, p. 101077.
Veraart, Luitgard A. M. and Iñaki Aldasoro. “CCPs United ▴ the hidden dangers of shared clearing membership.” SUERF Policy Brief, no. 549, 2023.
Duffie, Darrell. “Resolution of failing central counterparties.” Stanford University Graduate School of Business Research Paper, no. 14-5, 2014.
Ghamami, Samim, and Paul Glasserman. “Stress testing OTC derivatives ▴ Clearing reforms and market frictions.” Journal of Financial Stability, vol. 64, 2023, p. 101095.
Tian, Meng, and Haiyan Fan. “Systemic risk under different clearing methods for multiple derivatives.” Applied Economics, 2023, pp. 1-17.

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Reflection

The intricate network of central counterparties and their shared clearing members forms the bedrock of the modern financial system. Understanding the hidden dangers of this interconnectedness is paramount for any institution seeking to navigate the complexities of the derivatives market. The insights gained from this analysis should serve as a catalyst for a deeper examination of your own operational framework and risk management practices.

Are you prepared for a world where the failure of a single clearing member can trigger a cascade of events that reverberates across the entire financial system? The answer to this question will determine your ability to not only survive but thrive in an increasingly complex and interconnected world.