European Clearinghouses Devise Uniform Stress Testing Guidelines
A trade group of some of Europe's largest clearinghouses has come out with guidelines for stress testing to ensure they can withstand large scale shocks to the financial system -- and their members.
The guidelines drawn up by the European Association of Central Counterparty Clearing Houses (EACH) provides some inkling as to how clearinghouses should come up with hypothetical market scenarios and address defaults by member firms. Clearinghouses do conduct individual stress tests to determine if their default funds are large enough to cover potential losses -- the default of one or more clearing members. But the guidelines devised by the 23 clearinghouses are aimed at providing some consistency and could be used by global regulators to come up with uniform risk management procedures for all clearinghouses.
From a practical perspective, such uniformity will also help clearinghouses determine the value of assets the should have in their default funds which can be tapped in the event one or more members go bust. Both clearinghouses and their members contribute capital to those default funds. It is unclear whether the guidelines will preempt exchanges -- notably the London Stock Exchange -- from coming up with their own guidelines for clearinghouses wanting to take on their business.
"A CCP's stress-testing regime must fully recognize the unique status of CCPs as market infrastructures dedicated to risk management and subject to specific regulatory requirements," says the EACH in a statement. A full copy of the guidelines can be found on the EACH's website at http://www.eachorg.com. Among the EACH's 23 members are: the London Stock Exchange's Italian clearinghouse CCG, Depository Trust and Clearing Corp.'s subsidiary EuroCCP, the Deutsche Borse's Eurex Clearing; SIX x-clear and EMCF.
The EACH recommends that clearinghouses use the following qualitative and quantitative methodologies to come up with market events: amendments to historical scenarios; hypothetical economic "story-lines" with quantitative consequences; and extreme value theory. The clearinghouses should also take into account that one or more members might default either simultaneously or consecutively. A clearinghouse should also conduct stress testing daily and document all its procedures and results.
Regulators are concerned that clearinghouses may not be able to effectively handle the risk arising from clearing a much greater volume and range of financial instruments. So are broker-dealers and fund managers who are now handling transactions in the $700 trillion over-the-counter derivavtives market. Under current market practice they devise customized terms for how much collateral, if any, they post with each other and what they will do in the event of a default by one of the two counterparties. U.S. and European regulations now call for swap traders to electronically trade their contracts and process them through central clearinghouses which would guarantee payment between counterparties in the event of one's default. European regulations such as the proposed revisions to the Markets in Financial Instruments Directive are also calling for interoperability of clearinghouses -- a connectivity of sorts which will allow trades executed on a trading venue to be cleared in one of several clearinghouses.
Users of multilateral trading facility BATS Chi-X Europe can use one of four clearinghouses to clear trades on that platform while those trading on the London Stock Exchange have a choice between LCH.Clearnet and SIX x-clear.
Written by Chris Kentouris, Editor-in-chief (Chris can be contacted through chris.kentouris@hotmail.com).
