The CFTC summarized the results of a reverse stress test and a liquidation stress test of central counterparties ("CCPs"). The report is the third in a series of supervisory stress test exercises of CCPs (see coverage of the 2016 report and 2017 report). The tests were conducted in order to evaluate whether CCPs had sufficient pre-funded resources to meet payment obligations resulting from shortfalls of margin payments by member firms during times of market stress, and to meet costs associated with liquidating the positions of defaulting clearing members.
In the report, the CFTC studied CME Clearing and LCH Ltd using actual positions as of September 4, 2018, and the largest liquidation margin add-ons as of June 30, 3018. The reverse stress test found that the two CCPs have the necessary pre-funded resources to account for the potential default of all clearing members with losses. One such scenario in the test included market shocks of five times the size of those that occurred the day after Lehman Brothers announced bankruptcy.
The analysis of stressed liquidation costs also suggested that the CCPs would have sufficient pre-funded resources to cover extreme market losses and liquidation costs double the amount of liquidation margin add-ons. The CFTC stated that the purpose of this analysis was not a test of liquidation margin adequacy, but of whether the CCPs had the necessary pre-funded resources, in the event that the hedging and auctioning of a defaulting member exceeded their estimates.
The CFTC stated that both tests did not include the adequacy of assessment powers triggered by an exhaustion of pre-funded resources. The agency noted that although the tests revealed some shortfalls exceeding mutualized pre-funded resources, these shortfalls occurred under conditions "involving market losses [that] are likely implausible and likely exceed any historical market losses for these portfolios."
Commentary / Bob Zwirb
Clearing was described earlier this week by a CFTC commissioner as a "risk mitigation" measure. But it is less a risk mitigation or reduction measure than it is a risk transfer mechanism. And transferring such risk to an entity such as a clearinghouse concentrates it as a matter of course with systemic risk implications.
The stress tests conducted by the CFTC are reassuring in one sense, in that they give current CCPs a clean bill of health with respect to their ability to respond to member default. But that bill is subject to certain parameters that may or may not play out in real time. For example, the number of clearing members that cannot meet their obligations to the clearinghouse during times of stress may be more than those tests, or Dodd-Frank rules, assume. It is also subject to the truism that saving the clearinghouse may not be the same as saving the system.
Clearinghouses act as important levees in channeling credit and market risk, but those risks, like water, can flow further down the channel and emerge beyond the reach of the clearing system itself.
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