How Clearing Mitigates Risk
As market participants and regulators alike focus on solutions to prevent a future financial crisis, clearing has a center spot on the global stage. And there’s a reason: central clearing is a proven, highly transparent, regulated means of managing counterparty risk and reducing systemic risk.
Clearing houses maintain market integrity and capital protections by standing in the middle of each trade; once a trade is matched, the clearing house becomes the central counterparty (CCP) - the buyer to every seller’s clearing member and the seller to every buyer’s clearing member. The CCP also risk-manages trades to minimize any impact on clearing members and the larger market in the event of a default.
Why the CCP Model Works
Simply put, clearing protects clearing members and the broader market from defaults because it manages risk in an appropriate, disciplined and transparent manner - collateralizing (margining) each and every cleared position.
Each clearing house has unique risk management practices based on the products it clears and the risk associated with those products. The methods the ICE clearing houses use to manage risk include:
- Strict Membership Criteria – Initial and ongoing conservative membership standards.
- Initial Margin Collateral Requirement – Collateralizing (margining) each and every cleared position.
- Continuous Position Monitoring – Monitoring positions and margin throughout the day to make sure clearing risk is effectively managed as the value and size of our members’ positions change.
- Intraday Mark-to-Market Margining – The revaluation of cleared portfolios, on at least a daily basis, through settlement of variation margin or mark-to-market margin; this practice of requiring clearing members to pay their losses on at least a daily basis serves to avoid the accumulation of large losses over time. Clearing members with losing positions are held accountable as the market moves.
- Special Margin Calls – When intraday position losses breach certain margin thresholds, clearing houses have the discretion to make special intraday margin calls.
- Substantial Default Resources – Collecting and maintaining significant default resources that can be used in the event of a hypothetical member default.
- Rigorous Stress Testing – Running extreme but plausible market scenarios and what-if testing to determine the sufficiency of the clearing houses’ default resources.
- Transparency Standards – In addition to settlement prices that provide an independent pricing method for evaluating positions, a clearing house should have transparency standards that extend to providing straightforward and comprehensive documentation of fees and risk obligations. For each of ICE’s 6 clearing houses, that documentation can be found at theice.com/clearing. Our clearing houses operate based on clear and comprehensive sets of rules that enable our clearing members and other market participants to fully understand their risks, fees and obligations. Each of our clearing houses publishes its rulebook on the website and all rule changes are filed with regulators and posted online.
- Independent Risk Committees – The primary function of an independent risk committee is to provide oversight of clearing house activities and ensure appropriate risk mitigation steps are being taken. At ICE, our risk committees are a central component of our risk mitigation practices and are made up of banks, clearing firms and buy-side participants. They play an important advisory role to our clearing houses and help to protect market integrity while we innovate. Through close collaboration with our clearing houses’ risk committees, we’ve created more than 1,000 new products over the last 6 years to help market participants safely manage their risk.
As noted above, clearing houses help safeguard the market by managing the risk associated with extreme but plausible default scenarios. At ICE, we have detailed plans and procedures in place for the recovery of our clearing houses should circumstances require. In the unlikely event that a clearing member default is not absorbed through the margin and guaranty fund contributions of the defaulting clearing member, a recovery plan will be implemented that utilizes the significant financial resources of the clearing houses’ default waterfall.
To learn more about our recovery plans, read “Beyond the Waterfall: Essential Elements of a Clearing House Recovery Plan" written by Scott Hill, CFO, Intercontinental Exchange, and published in the June 2017 issue of MarketVoice.