Membership requirements. The most basic means of controlling counterparty credit and liquidity risks is to deal only with creditworthy counterparties. Clearing houses typically seek to ensure that their members are creditworthy by establishing a set of financial requirements for membership. Usually clearing members are required to meet, both initially and on an ongoing basis, minimum capital requirements, often stated as the larger of a fixed amount and a variable amount that depends on some measure of the scale and riskiness of the firm's positions with the clearing house and in other financial markets. In most cases, membership is restricted to regulated entities that meet regulatory minimum capital requirements. Clearing firms that carry client accounts are often required to meet capital standards that are more stringent than regulatory minimum requirements. Of course, compliance with regulatory capital requirements does not by itself ensure that a firm can meet extraordinary demands for liquidity, including those that can be placed on clearing members by dramatic changes in prices of exchange-traded derivatives. Clearing houses typically do not impose specific requirements on clearing member liquidity (beyond those implied by capital requirements), but some clearing houses do periodically review their members' access to funding, especially their bank credit lines.

Information on compliance with regulatory capital requirements is often available only at discrete intervals, for example, monthly or quarterly. Given the considerable leverage and liquidity achievable through use of derivatives and other financial instruments, risk profiles of clearing members may change dramatically between regulatory reporting dates. For this reason, many clearing houses (or the exchanges for which they clear) conduct surveillance of members' positions on an ongoing basis. At a minimum, surveillance efforts cover activities on the exchange (or exchanges) for which the clearing house intermediates. However, the financial health of a clearing member generally cannot be accurately assessed without information on activities in other markets as well.²⁵ For this reason, exchanges, clearing houses and their regulators have been working to develop and expand information-sharing agreements with respect to common members.²⁶

In addition to financial requirements, most clearing houses establish standards of operational reliability for clearing members. As will be discussed below, clearing houses typically impose tight deadlines for the submission of trade data and for completing various settlement obligations.²⁷ The failure of a clearing firm to meet these tight deadlines could significantly increase the clearing house's risk exposures to that clearing member and possibly to other clearing members as well. Compliance with operational deadlines is closely monitored on a day-to-day basis. Furthermore, in recent years many clearing houses have been paying greater attention to the backup systems that clearing members would have available if their primary operating systems were disrupted.

While a clearing house's membership requirements are an extremely important safeguard, they are not intended, and cannot be reasonably expected, to eliminate the possibility of a clearing member's failure. Capital requirements typically are not designed to cover potential losses from all possible price movements, and even the most comprehensive surveillance programme cannot be expected to detect, much less prevent, every incipient financial problem at every clearing member. Moreover, by creating highly concentrated exposures to a very small number of clearing members, extremely stringent membership requirements could actually increase rather than decrease the clearing house's risk.

Margin requirements.²⁸ In practice, clearing houses are able to permit fairly broad membership because the risk of losses from members' defaults is mitigated substantially by the use of margin requirements. All clearing houses impose initial margin requirements, that is, requirements to provide collateral (or guarantees) to the clearing house to cover potential future losses on open positions in both futures and options.²⁹ In addition, in the case of futures contracts, clearing houses nearly always impose variation margin requirements, that is, requirements that clearing members make periodic payments to the clearing house (and that the clearing house make periodic payments to clearing members) to settle any losses (gains) that have accrued on the clearing member's contracts since the previous variation settlement.³⁰ In the case of options contracts, while a few clearing houses impose variation margin requirements, most do not. In the most common approach, which is termed an "options-style" or "premium upfront" margining system, the buyer of an option contract is required to pay the option premium at the inception of the contract and is not required to post initial margin; the seller of the option receives the premium at inception and is required to maintain initial margin to cover the sum of the current market value of the option (initially equal to the premium) plus a cushion for potential future increases in the option's market value. By contrast, in a "futures-style" margining system, the buyer does not pay and the seller does not receive the premium upfront. Instead, as in the typical case for futures contracts, both buyer and seller are required to post initial margin and are required to make (or are entitled to receive) daily variation settlements.³¹

Both futures-style and options-style margining systems are designed so that in the event of a default by a clearing member a substantial portion of any losses on its positions could be covered by liquidating the margin collateral that it has posted. Futures-style margining periodically eliminates current credit exposures to clearing members through money settlements of any losses or gains arising from changes in market values of positions, while options-style margining collateralises current credit exposures to clearing members (the current market value of their positions). Both futures-style margining and options-style margining seek to collateralise potential future credit exposures to clearing members.

Regardless of whether futures-style or options-style margining is employed, the key determinants of the extent of protection against credit losses that is provided to the clearing house are: (1) the procedures used to determine the level of margin required, including the percentage of potential losses that the clearing house intends to cover and the reliability of the methodology it uses to estimate potential losses; (2) the price stability and liquidity of the assets accepted as margin collateral by the clearing house; and (3) the frequency of settlements of initial margin deficits (surpluses) and variation losses (gains).

Margin requirements are not designed to fully collateralise a clearing house's exposures to its clearing members in all market conditions. Rather, clearing houses seek to strike a balance between the risk reduction benefits of greater collateralisation and the opportunity costs that greater collateralisation imposes on their members. Faced with this trade-off, most clearing houses have tended to set margins at levels intended to cover from 95 to 99% of potential losses from movements in market prices over a one-day time horizon.³² Clearly, a broader intended coverage will tend to provide a greater degree of protection to the clearing house. Equally important, however, is the robustness of the methodology the clearing house uses to measure potential losses from market price changes. A weak methodology could well produce coverage that is significantly less than intended. Use of a sound methodology has become increasingly important as options on futures have accounted for growing shares of total open positions on many futures exchanges. When options were first introduced, many clearing houses ignored the non-linear relationship between option values and changes in the value of the underlying asset, which tended to produce underestimates of potential losses on options positions, especially when the value of the underlying asset changed significantly. Moreover, they often used relatively simple and arbitrary rules to account for the potential for changes in the value of different contracts to offset one another (portfolio effects).

In recent years, most clearing houses have begun to assess potential changes in option values through the use of option pricing models which take account of non-linearities and also account for other sources of changes in option values, notably changes in the expected volatility of the price of the underlying asset, by performing full revaluations of option values at different values of the underlying asset and the underlying's volatility.³³ The use of option pricing models also allows portfolio effects to be assessed more precisely. Nonetheless, option prices can diverge significantly from model values, especially when the price of the underlying asset changes significantly. The more sophisticated clearing houses recognise this and make judgemental adjustments to model-based margin requirements, for example, minimum requirements for deep-out-of-the-money short option positions.

The types of assets accepted as margin collateral by a clearing house also affect the degree of protection against credit losses that is provided by its margin requirements. The assets accepted typically include cash, short-term domestic government securities and, in many cases, some form of bank guarantees (for example, standby letters of credit). Longer-term government securities, other debt instruments and equities also are accepted fairly frequently, but the collateral value assigned to such securities is typically less than the market value by a percentage "haircut" that reflects the potential for the value of the security to decline.³⁴ In recent years, many clearing houses have begun accepting collateral denominated in currencies other than the currencies in which the exchange's contracts (and, therefore, the resulting payment obligations) are denominated. In such circumstances, additional haircuts may be applied to the asset values to reflect the potential for exchange rate changes to diminish the value of the collateral.

The last of the three key determinants of the degree of protection against credit losses provided by margin requirements is the frequency of settlements of initial and variation margin. Most clearing houses currently conduct one settlement each day. After the close of each trading day, the clearing house calculates initial margin deficits and surpluses, based on open positions as of the end of the day, and variation losses and gains, based on closing prices. Settlement of these obligations typically occurs early on the following business day, if possible before the opening of trading.³⁵ However, as will be discussed below, the funds (and securities) transfers associated with the settlements sometimes do not become final until later in the day.

In recent years, several clearing houses have introduced a second routine intraday margin call during the afternoon. Most other clearing houses have the authority to make intraday margin calls. In some cases, a margin call occurs automatically if market prices change sufficiently, for example, if a price limit has been reached.³⁶ Some clearing houses also have the authority to make selective margin calls, that is, to require settlement by some but not all clearing members, for example, only by those clearing members whose variation losses or initial margin deficits exceed some predetermined (and possibly firm-specific) threshold.

More frequent margin settlements clearly tend to reduce a clearing house's credit exposures. However, the extent of risk reduction depends on several key factors. The benefits may, in fact, be illusory if the settlements involve provisional rather than final transfers of funds to the clearing house. For example, multiple intraday margin calls may not produce any meaningful reduction of credit exposures if settlements are effected through a funds transfer system that could unwind, that is, rescind a transfer from a clearing member to the clearing house at the end of the day if the clearing member cannot cover its net payment obligation. Likewise, if initial margin deficits are met by transferring eligible collateral to the clearing house, such transfers do not effectively reduce risk unless they are final transfers. In the case of securities, for example, transfers in many settlement systems are provisional pending end-of-day net settlement of the associated money transfers. Finally, the benefits are greater to the extent that the clearing house is able to incorporate in the calculation of margin requirements a larger share of trades that have been executed and matched since the last settlement. The clearing house's capacity to incorporate new trades depends, in turn, on the speed with which its systems can compute new estimates of open positions and can capture the latest market prices.³⁸

While the degree of protection against credit losses provided by futures-style margining and options-style margining depends primarily on the underlying factors that have just been discussed, rather than on the choice between the two approaches, the use of options-style margining tends to reduce the vulnerability of a clearing house to liquidity pressures. In a futures-style margining system, at each settlement the clearing house must pay out to its members gains on outstanding open positions, while in an options-style margining system it pays out premiums collected as a result of new options sold. Ordinarily, the aggregate amount of such payments to clearing members is matched by the aggregate amount of receipts from clearing members. However, if a clearing member defaults, the clearing house would be faced with a shortfall of liquidity equal to the amount of funds owed by the defaulting clearing member. In general, the potential amount owed and, therefore, the potential liquidity shortfall would tend to be larger in a futures-style margining system than in an options-style margining system. Moreover, to the extent that a clearing house relies on liquidating margin collateral of a defaulting clearing member to cover liquidity shortfalls,³⁹ the amount of initial margin tends to be larger under options-style margining, because initial margin must cover current exposures (current market values) as well as potential future exposures.

In other respects, the determinants of potential liquidity pressures from a clearing member's default would be the same under futures-style margining as under options-style margining. In either case, more frequent settlements could reduce potential liquidity pressures from a default by reducing the amount of funds that need to be collected and paid out at any one settlement. However, if the funds transfers involved are provisional, the subsequent unwinding of transfers could place substantial liquidity pressures on the clearing house, especially if the clearing house does not learn of the unwind until late in the day.

Also, the capacity of the clearing house to meet liquidity pressures would depend, in part, on the liquidity of the margin collateral posted by the defaulting clearing member. Short-term government securities can ordinarily be sold quite promptly, either outright or under a repurchase transaction. But the same-day sale or financing of other securities may be difficult, especially in the turbulent conditions that may be the cause or consequence of a clearing member's default. As an alternative, securities might be pledged to secure bank loans. The liquidity of bank guarantees depends on how quickly the contract obliges the bank to provide the clearing house with funds in the event of a default. Even cash margin may not produce funds for a clearing house in time to meet liquidity pressures from a default if the clearing house has invested the funds. In general, the speed with which margin assets can be transformed into cash may depend critically on how quickly the relevant interbank funds transfer and securities transfer systems can achieve finality. If those systems are netting systems with end-of-day settlements, the clearing house may have great difficulty meeting an earlier deadline.

Default procedures. As has been observed, clearing houses typically base levels of margin requirements on a statistical analysis of potential losses over a one-day time horizon. The use of a one-day horizon implicitly assumes that a clearing house is able and willing to take action to eliminate its credit exposure to a clearing member within one day from its last settlement of any initial margin deficits or variation losses.⁴⁰ In the event of a clearing member's default, typically its house positions would be closed out, that is, the clearing house would enter into offsetting trades on the exchange,⁴¹ and the margin collateral supporting those positions would be liquidated as soon as possible. Alternatively, if the exchange was perceived to be temporarily illiquid, the clearing house would usually have the discretion to delay liquidation of positions to avoid further disruptions to the market and what may prove unnecessary liquidation costs. In the interim, the house positions might be hedged in other markets to reduce vulnerability to adverse price changes.⁴² Most clearing houses would seek to transfer a defaulting clearing member's clients' positions and margin collateral to other non-defaulting clearing members.⁴³ Under the rules of a few clearing houses, however, clients' positions would be closed out and their margins liquidated, even if none of the clients had defaulted on their obligations to the defaulting clearing member.⁴⁴

As discussed, most clearing houses conduct one routine margin settlement per day, based on positions and market prices at the end of the trading day. The funds transfers associated with the settlement are typically effected early the next day, although in some cases they do not become final until late the next day. In effect, a settlement of losses and margin deficits that arise because of changes in market prices and clearing members' open positions between the end of day T-1 and the end of day T are settled early on day T+1.⁴⁵ If final settlement occurs before the opening of trading on the exchange, a clearing member's default would become apparent within one trading day of the last margin settlement. If not, more than one trading day would have elapsed. In any event, a clearing house generally could not begin to close out a defaulting member's positions until after trading reopens on T+1, and this process could not be completed instantaneously. Thus, under the best of circumstances, a clearing house that conducts a single margin settlement each day would, in fact, need something more than one day to eliminate its counterparty exposures on positions that a defaulting clearing member had held as of the end of T-1.

The longer a defaulting member's positions remain open, the larger are the potential credit exposures on those positions.⁴⁶ Thus, a key issue is how quickly the defaulting clearing member's positions could be closed out. This would depend on the size of the defaulting member's positions and the liquidity of the markets in which they were held. To the extent that large open positions were held in illiquid markets, several days might be required. Furthermore, even if the markets in which the positions were held were ordinarily quite liquid, a default by a market participant, especially a large participant, could significantly reduce liquidity. Also, if the contract were subject to price limits, liquidation would not be possible as long as the limits were binding. In all these circumstances, the clearing house may have authority to hedge the open positions in other markets, but the hedges are likely to be imperfect at best.

Finally, the defaulting clearing member may have increased the size of its open positions since the last margin settlement. Because the last margin settlement on T would have been based on positions as of the end of T-1, these larger open positions could have been established at any time on T or, if final settlement on T+1 occurs after the opening of trading, earlier on T+1. Additional losses might result from closing out these positions, on which no initial margin would have been collected.

In sum, while margin requirements provide substantial protection to a clearing house, the preceding analysis has identified several reasons why the default of a clearing member could lead to losses that would exceed the value of the collateral it had posted with the clearing house to satisfy margin requirements. First, margin requirements are not intended to cover losses from all possible price movements, and the actual statistical coverage may be less than intended. Second, although margin requirements typically are based on estimates of potential losses over a one-day time horizon, if markets are illiquid or legal difficulties constrain the clearing house, more than one day may elapse before it can eliminate its credit exposure to the defaulting member, and while positions remain open, exposures can grow larger. Third, the defaulting member may have increased the size of its open positions since the last margin settlement.

Supplemental clearing house resources. Clearing houses recognise the potential for losses to exceed the value of a defaulting member's margin collateral, and maintain supplemental financial resources that are available to cover such uncollateralised losses as well as to provide liquidity during the time it takes to realise the proceeds of the defaulting member's margin assets. In most cases these supplemental resources are either assets owned directly or indirectly (through the clearing house) by the clearing members or contingent claims on the clearing members. Thus, utilising these resources has the effect of sharing (mutualising) uncollateralised losses among clearing members.⁴⁷ These resources can take many specific forms ­ capital and reserves, clearing guarantee funds (collateral pools owned by clearing members but under the control of the clearing house or cash deposited by clearing members with the clearing house in accounts separate from margin accounts), committed lines of credit arranged by the clearing house, insurance policies, guarantees provided by members, or authority to make assessments on members.

However, the size of such supplemental resources varies considerably from clearing house to clearing house. Moreover, the resources that are available may not be sufficiently liquid that they could be mobilised quickly enough to allow the clearing house to meet its obligations without delay. For example, assessments on members typically are not payable until a day or more after the clearing house makes a request. The liquidity of bank credit lines and guarantees depends critically on how promptly and reliably banks are obligated to make funds available. Even capital and reserves and clearing fund contributions are typically invested, and the investments may not mature, or, if salable, may not produce cash proceeds, until after (in some cases well after) the clearing house would need to make payments.

Position limits. Almost all clearing houses (or the exchanges for which they clear) impose some form of position limits, that is, limits on the number of contracts or the percentage of total open interest in a contract that a single client (or single clearing firm) can hold. In many cases, however, such limits are imposed primarily to inhibit the ability of market participants to manipulate prices, and they may not apply to contracts for which the deliverable supply is large or essentially unlimited or to positions that are considered non-speculative. As noted earlier, whether or not formal position limits are imposed, clearing houses typically monitor clearing members' positions, and they often have the authority to require reductions in positions if they give rise to prudential concerns. Some clearing houses integrate position limits into their risk management system more formally. For example, position limits for individual contracts may vary across clearing members, with the limit applied to an individual member proportional to its capital. In addition, some clearing houses limit the aggregate positions (across contracts) of individual clearing members to a specified percentage of capital. When position limits are more formally integrated into risk management, they are often termed risk-based position limits.

Footnotes:
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