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Central Clearing – stability for financial markets

Central Clearing – stability for financial markets

Clearing works a bit like PayPal, the well-known online payment system:  when you shop online and pay via PayPal, you don’t directly pay the online shop you visit. You’re paying PayPal, and they in turn pay the shop you bought from – taking on any risk in the transaction between you and the company you’re buying from.

It’s the same principle for clearing securities via entities known as central counterparties like Eurex Clearing, with the main purpose being to mitigate counterparty risks in securities trading. As soon as a buyer and a seller agree on a trade via an exchange organisation, the central counterparty comes into play as the middleman to “clear” the trade. The central counterparty becomes the seller to the buyer, and the buyer to the seller. Central counterparties reduce the risk in securities trading because they guarantee that the trades will take place, regardless of whether the buyer goes bust or the seller doesn’t have the securities.

Video: central counterparty (CCP) ... in simple terms


Obviously, there needs to be some guarantee that the central counterparty won’t go bust itself for this to work. This is achieved in several ways – the so-called lines of defense: firstly, both the buyer and the seller have to provide collateral for the trade – assets that will be transferred to the central counterparty if they can’t deliver on the day of the trade. Secondly, all organisations that make use of a central counterparty (known as clearing members) have to make a contribution to the default fund – an emergency clearing fund. This is an extra safety measure if the collateral of a trade is not sufficient to cover the central counterparty’s costs. This model has been proven to work well, and you can see a recent example of it in action in Eurex Clearing’s handling of the Maple Bank default not so long ago:

Video: how Eurex Clearing handled the default of Maple Bank


Stress testing at Eurex Clearing

Eurex Clearing's foremost objective is to fulfil its obligations as a central counterparty. The Clearing House must perform this role in both normal and extreme market conditions. In fact, Eurex Clearing has defined safeguards for the most extreme market conditions. They stipulate that obligations will be backed in 999 out of 1,000 events by the margin requirements and financial reserves available in cases of default. Default backing includes the collaterals and the Clearing Fund contribution of a defaulting member, the reserve fund of Eurex Clearing and Clearing Fund contributions of non-defaulting members, in that precise order.


The stress test procedure

Eurex Clearing has a stress test procedure in place that aims to ensure that default backings are sufficient to cover the risk exposure of defaulting Clearing Members in the most extreme market conditions. Each Clearing Member's risk exposure is stress tested against a comprehensive set of scenarios for all the product groups that Eurex Clearing clears. Scenarios include the worst historical events experienced in the past for each product type as well as executive management's expectations of the worst potential future price movements. Scenarios based on historical events are mainly of two types:

  • Price movements across all product groups on specific crisis days
  • Historically largest moves per product group irrespective of a particular day

The stress test is performed on the risk exposure of each Clearing Member. Potential losses based on stress scenarios are compared to each member's additional margin. Losses beyond additional margin are then compared to the Clearing Fund. How much of the Clearing Fund would be consumed by the theoretical stress test calculations is identified and analysed on a daily basis. In fact, intraday stress tests are performed by Eurex Clearing in extraordinary market situations.

Should the demands made on the Clearing Fund by a Clearing Member — irrespective of its creditworthiness — breach a pre-defined threshold, the Eurex Clearing board decides on risk mitigating actions. Risk mitigating actions include member-specific actions, for example extra margin requirements or enlarging the size of the Clearing Fund by increasing the Clearing Fund contribution of all members. The stress test scenarios and procedure are subject to regular review.


Improving the reliability of off-exchange transactions  

The fact that central counterparties help to ensure that trades don’t fail is one of the key reasons why regulators since the financial crisis have been increasing mandatory central clearing not just for trades conducted on-exchange, but also off-exchange for “over the counter” trades. This is done through a process called “novation”, where the central counterparty steps in after a trade has already been made between two parties. Here the trade has been made elsewhere, but the payment and delivery is nevertheless managed via a central entity.

In addition, for trades that cannot be cleared via a central counterparty, regulators are also trying to introduce some of the risk reduction techniques described above – in particular requiring both parties to a trade to post collateral (known as initial margin and variation margin) to a separate account in case of default.