Two central counterparties (CCPs) have experienced clearing member defaults over the past five years that have exceeded the defaulting member’s contribution to default resources and required the use of mutualized resources in the default fund, spreading losses to other CCP participants. These defaults – which occurred in the futures segment of the Korea Exchange and, more recently, at Nasdaq Clearing in Europe – have highlighted weaknesses in some CCP risk management practices and underscore the importance of a more consistent implementation of risk management best practices by CCPs around the world.
This paper outlines ISDA’s current thinking on clearing risk management best practices. Fundamental to these practices is the principle that CCP risk management decisions should be based on the risk profile of a given derivatives product. These best practices call for a holistic, multifaceted and dynamic product-based approach. It is insufficient to rely on a single risk factor as the determinant for exposure – for example, whether it is classified as an exchange-traded or over-the-counter (OTC) derivative. As markets evolve, risk management must also adapt.
ISDA and its members call for broad-based implementation of these best practices to ensure that CCPs have:
Risk controls and margin requirements that adapt to concentration, liquidity, member credit quality and wrong-way risk in a member’s portfolio;
Effective and transparent default management processes; and
Robust membership criteria and greater assurances of continued adherence to them.
Most importantly, these practices will ensure that, outside of an extreme stress event, the default of a member will not be propagated to other members or the wider financial system.