The Study Group does not mean to imply that systemic risk considerations require any individual clearing house to take any of the steps identified. At current levels of activity, existing safeguards may in most cases be adequate to ensure that the clearing house can cover any losses and liquidity pressures, even under extremely difficult market conditions. Furthermore, some of the steps identified, particularly those that are designed to ensure that potential losses and liquidity pressures from clearing member defaults can be contained, are clearly alternative means of achieving risk reduction, should that be deemed appropriate. Finally, in particular circumstances steps other than those identified by the Study Group might offer the most cost-effective means of reducing risk. Nonetheless, the Study Group believes that clearing houses should carefully consider whether implementation of the steps discussed below could produce benefits that exceed the costs. Public benefits in terms of reduced systemic risk would accrue from these steps, and it should be noted that each of the steps has already been taken by some clearing houses in the G-10 countries.

Stress testing. As discussed in Section 5, the typical approach to managing credit and liquidity exposures to clearing members is perhaps most vulnerable to defaults induced by extreme movements in the prices of contracts that the clearing house itself clears, that is, price movements in excess of the amounts the clearing house provided for in setting margin requirements. Clearing houses maintain supplemental financial resources to meet potential losses and liquidity pressures from such extreme price movements, but the magnitude of the potential pressures and the adequacy of those supplemental resources cannot be readily determined.

To do so requires stress testing, that is, the selection of extreme price scenarios and the estimation of credit and liquidity exposures that would result from their realisation.⁶¹ The selection of scenarios may be based on historical data (for example, maximum historical price changes) or on statistical modelling of potential future price movements (and changes in implied volatilities of price movements). Whichever approach is taken, the choice of scenarios inevitably requires judgements about the possibility of future events that are simply unknowable. Once price scenarios have been chosen, their effects on contract values must be estimated. This may not be straightforward if the contracts cleared include options. An option pricing model must be utilised and, whatever model is selected, its ability to predict market values in market conditions that may lie outside historical experience is unclear.

Perhaps half the clearing houses in the G-10 countries currently have formal stress testing programmes. In some cases, the results are used to limit exposures to clearing members. If an estimated exposure is too large relative to the member's capital, the member may be requested to reduce its positions or to post additional margin collateral to support the positions. In a few cases these actions are mandatory and automatic. In addition (in some cases, as an alternative), clearing houses use stress tests to assess periodically the adequacy of the size and liquidity of their financial resources. However, in most cases those resources do not appear to be augmented automatically when the tests point to deficiencies.

Given their possible vulnerability to endogenous defaults stemming from extreme price movements, the implementation by clearing houses of routine and frequent stress testing has the potential to contribute significantly to addressing concerns about vulnerabilities in clearing systems for exchange-traded derivatives and about the potential for such vulnerabilities to create systemic problems. However, if these benefits are to be fully realised, it is important that the use of such tests be accompanied by a commitment to limit exposures or to augment resources when necessary to ensure that the clearing house can cover the simulated losses and meet its obligations on schedule.⁶²

Enhanced intraday risk management. As has been discussed, clearing houses typically conduct one routine settlement per trading day, usually on the basis of positions and position values as of the end of the previous trading day. Most also have the capacity to conduct one or more intraday settlements, either routinely or when large price movements have produced unusually large exposures. However, to date the benefits of these procedures have been limited in many cases by lags in receiving and processing information on intraday exposures and, in some cases, by reliance on payment systems and securities settlement systems that do not achieve finality until at or near the end of the business day.

Recent and prospective improvements in exchanges' and clearing houses' trade processing capabilities and in interbank payment systems and securities settlement systems are significantly enhancing the potential for clearing houses to reduce credit and liquidity exposures to clearing members by implementing more frequent calculation of margin deficits and variation losses and by developing the capacity for more frequent settlements of such amounts. Most clearing houses for exchanges employing screen-based trading systems have true real-time information on clearing members' open positions and variation losses, although not necessarily on initial margin deficits.⁶³ Likewise, many clearing houses for exchanges that utilise open-outcry trading have tightened deadlines for the input of trade details and have improved trade matching and processing systems to the point where the same information is available intraday and, in some cases, on nearly a real-time basis. Thus, most clearing houses are now able to monitor credit exposures and potential liquidity exposures to their members on an intraday basis, and some can monitor such exposures on a real-time basis.

Meanwhile, central banks in most of the G-10 countries have introduced or plan to introduce interbank payment systems that are RTGS systems or deferred net settlement systems that achieve multiple final settlements throughout each business day. The existence of such payment systems will allow clearing houses in those countries not only to monitor their exposures to clearing members on an intraday basis but also to actively manage those exposures on an intraday basis through the collection of variation margin.⁶⁴ Intraday use of securities collateral to cover initial margin deficits is also becoming possible in a growing number of countries, as more securities settlement systems have permitted final intraday transfers of securities from clearing members to the clearing house.

Such intraday settlements could be carried out routinely, perhaps at or near the end of the day, so as to reduce or collateralise the overnight credit exposures to clearing members that clearing houses typically bear today. Alternatively, intraday settlements could be made only in circumstances in which market volatility or surges in trading volumes produce unusually large exposures. Furthermore, settlements could be effected with all clearing members or only with clearing members to which the clearing house has significant exposures. By these means, the costs to the clearing house and its members of more active risk management could be minimised. For example, one clearing house is reportedly considering setting exposure limits vis-à-vis each clearing member as a percentage of the member's capital and calling for cash or collateral from a member on an intraday basis if, and only if, its intraday exposure to that member exceeds the limit set.

Such an approach, if based on real-time information on positions and position values, would come as close as is possible to achieving real-time control of credit and liquidity exposures to clearing members. However, for two reasons true real-time control of exposures simply is not possible. First, clearing houses usually do not have real-time control over a clearing member's open positions.⁶⁵ To achieve real­time control of positions, the clearing house would need to be able and willing to reject trades that increased open positions. As discussed in Section 3, some clearing houses are obligated to serve as counterparty to all matched trades executed on the floor of any exchange for which they clear. While others have the right to reject matched trades (in some cases until as late as the following morning's margin settlement), they may be quite reluctant to exercise this right, because doing so would force their clearing members to bear any counterparty credit losses on the rejected trades.^66,67 Second, even if a clearing house could achieve real-time control of a clearing member's open positions, real-time control of exposures on these positions would not be possible. Those exposures depend on changes in market prices, which ultimately depend on supply and demand. As already discussed, sharp changes in prices can result in sudden increases in exposure, which could increase further during the time that is allowed to meet an intraday margin call and the additional time that would be required to close out open positions in the event that such a call were not met.⁶⁸

Nonetheless, with improvements in trade matching and processing systems and the availability of real-time payment and securities settlement systems, the size of potential losses and liquidity pressures from clearing member defaults can be reduced very substantially through intraday settlements. One further caveat should be noted, however. The implementation of intraday settlements will require clearing members to respond to settlement requests quite promptly. Also, should a clearing member fail to respond, the clearing house would need to mobilise its liquidity resources quite quickly to meet its obligations.⁶⁹ The introduction of new real-time payment and securities settlement systems will offer opportunities to clearing members and clearing houses to enhance significantly their capacity for meeting liquidity demands promptly. But they will need to be aware of the potential demands and take steps to ensure that they can take advantage of the new opportunities. Otherwise, more frequent settlement could, in fact, exacerbate rather than mitigate potential liquidity problems.

Strengthening money settlement arrangements. Clearing houses that currently use payment systems that are deferred net settlement systems can strengthen their money settlement arrangements as central banks implement new RTGS payment systems or extend the hours of operation of existing systems.⁷⁰ Clearing houses that use the central bank as settlement bank will be able to reduce the duration of their credit exposures to clearing members. They will also be able to eliminate the spectre of unmanageable liquidity pressures from the unwind of a large payment by a clearing member late in the business day when liquidity resources would probably be very difficult to mobilise. Nonetheless, these clearing houses will need to review their ability to mobilise their liquidity resources quickly. To the extent that a clearing house relies on securities collateral for liquidity, the existence of securities settlement systems that allow final intraday transfers of securities should prove quite useful, and more such systems are likely to be implemented once RTGS payment systems are in operation.⁷¹ To the extent that it relies on bank guarantees or credit lines, these agreements must require the banks to make funds available to the clearing house in time for it to meet its obligations without delay. Although RTGS payment systems should ease liquidity management by allowing more rapid mobilisation of funds, clearing houses, clearing members and banks will need to prepare to meet the intraday deadlines that will be part of an RTGS world.⁷²

Clearing houses that use private settlement banks will be able to reduce the duration of their credit exposures to settlement banks and their vulnerabilities to severe and potentially unmanageable liquidity pressures from the unwind of a provisional payment from a settlement bank by using an RTGS payment system for balancing transfers among the settlement banks.⁷³ In fact, if each settlement bank at which clearing members on net owe the clearing house funds could be relied upon to instantaneously transfer those funds to a settlement bank at which clearing members are owed funds by the clearing house, the clearing house's credit exposures to settlement banks would be effectively eliminated.⁷⁴ However, the possibility would always exist that a settlement bank would fail to make a required transfer prior to its insolvency.

Like clearing houses that use the central bank as settlement bank, if clearing houses that use private settlement banks are to take advantage of the new opportunities created by an RTGS environment, they will need to review the adequacy of their liquidity resources and, if necessary, make changes to meet intraday settlement deadlines. They may also need to modify their settlement agreements to require the settlement banks to use the RTGS payment system to complete balancing transfers between settlement banks as soon as possible after final transfers from clearing members to the clearing house. The renegotiation of settlement agreements would provide an opportunity to review whether those agreements address obligations in the event of a default by a clearing member or settlement bank with sufficient clarity and, where necessary, to eliminate any existing ambiguities.

Footnotes:

⁶¹ In addition to assessing the impact of extreme price scenarios, stress tests might also assess the potential for exposures to exceed margin requirements because of violations of other assumptions underlying their calculations, for example potential changes in implied volatilities of options or in correlations between the prices of different assets. For a general discussion of stress testing of estimates of potential changes in the value of a portfolio of financial assets, see pages 46-47 of Basle Committee on Banking Supervision (1996).

⁶² In a different but related context, the need to take appropriate action in response to stress test results was recognised by the Basle Committee on Banking Supervision (1996), whose standards for the use of banks' internal models for determining minimum capital requirements for market risk required that "[stress test] results be reviewed periodically by senior management and ... reflected in the policies and limits set by management and the board of directors".

⁶³ Intraday computation of initial margin deficits in gross margining systems may be especially difficult, because it would require information on the effects of trading on the open positions of individual clients and such information is often available only at the end of the day.

⁶⁴ Where private settlement banks are used, this already is possible. Nonetheless, RTGS payment systems can facilitate the funding of margin calls by clearing members and can allow the duration of a clearing house's intraday exposures to private settlement banks to be reduced.

⁶⁵ By contrast, payment systems and some securities settlement systems achieve real-time control of the system's exposures to participants by routinely rejecting (or holding pending) funds or securities transfer instructions that would create an exposure in excess of a limit.

⁶⁶ As discussed in Section 3.1, under exchange rules clearing members typically do not have the capability to manage counterparty credit risks vis-à-vis other clearing members.

⁶⁷ A clearing house typically does have the authority to suspend a clearing member, which would bar further trading by the member and its clients but generally would not lead to rejection by the clearing house of trades executed prior to the suspension.

⁶⁸ Market price changes can be temporarily limited by price limits or trading halts (sometimes collectively referred to as "circuit breakers"). While such limits would place an upper bound on the clearing house's potential liquidity exposures, they would not bound its credit exposures, because the clearing house may not be able to close out open positions until the price limits are lifted.

⁶⁹ This assumes that the clearing house pays out as well as receives funds as part of the intraday settlement. This may not be necessary if a small amount of funds are being collected, but the collection and retention of a large amount might place substantial pressures on money markets and payment systems.

⁷⁰ Even the implementation of deferred net settlement systems that establish multiple intraday processing cycles with finality achieved at the end of each processing cycle would allow clearing houses to significantly reduce risks.

⁷¹ In the absence of a securities settlement system that provides intraday finality, a clearing house may need to identify lenders willing to accept the securities as collateral and pre-position the securities with those lenders.

⁷² Clearing houses will also need to be mindful of the constraints on the availability of intraday central bank credit in the new payment systems. In many countries such credit will be made available only if the borrower has collateral that is acceptable to the central bank. At times of stress there are likely to be many competing demands for collateral, which may produce a shortage of collateral and delays in completing payments.

⁷³ This assumes that the central bank's RTGS payment system is operating at the time the clearing house seeks to settle.

⁷⁴ The clearing house may be owed more by clearing members than it owes to clearing members because, for example, of increases in initial margin requirements. If so, settlement banks receiving the surplus could be instructed to instantaneously invest the funds on the clearing house's behalf with an unaffiliated third party.