Financial Stability Standards for Central Counterparties Standard 4: Credit Risk
Note: The headline standard and numbered ‘sub’-standards determined under section 827D(1) of the Corporations Act 2001 have been formatted in bold text while the guidance to these standards has been formatted as plain text. For more information see the Introduction for Standards and Introduction for Guidance. Although the Reserve Bank has taken due care in compiling this page, the published version of the Standards and Guidance should be used in the case of any differences between the two.
A central counterparty should effectively measure, monitor and manage its credit exposures to participants and those arising from its clearing processes. A central counterparty should maintain sufficient financial resources to cover its credit exposure to each participant fully with a high degree of confidence.
Guidance
Credit risk is broadly defined as the risk that a counterparty will be unable to meet fully its financial obligations when due or at any time in the future. The default of a participant (and its affiliates) has the potential to cause severe disruption to a central counterparty, its other participants and the financial markets more broadly. Therefore, a central counterparty should establish a robust framework to manage its credit exposures to its participants and the credit risks arising from its clearing processes (see also CCP Standard 3 on the framework for the comprehensive management of risks, CCP Standard 9 on money settlements and CCP Standard 15 on custody and investment risks). Credit exposures may arise in the form of current exposures, potential future exposures, or both. Current exposure, in this context, is defined as the loss that a central counterparty would face immediately if a participant were to default.[1] Potential future exposure is broadly defined as any potential credit exposure that a central counterparty could face at a future point in time.[2] The type and level of credit exposure faced by a central counterparty will vary based on its design and the credit risk of the counterparties concerned.[3]
4.1 A central counterparty should establish a robust framework to manage its credit exposures to its participants and the credit risks arising from its clearing processes. Credit exposures may arise from current exposures, potential future exposures, or both.
4.1.1 A central counterparty typically faces both current and potential future exposures because it typically holds open positions with its participants. Current exposure arises from fluctuations in the market value of open positions between the central counterparty and its participants.[4] Potential future exposure arises from potential fluctuations in the market value of a defaulting participant's open positions until the positions are closed out, fully hedged or transferred by the central counterparty following an event of default.[5] For example, during the period in which a central counterparty neutralises or closes out a position following the default of a participant, the market value of the position or asset being cleared may change, which could increase the central counterparty's credit exposure, potentially significantly.[6] A central counterparty can also face potential future exposure due to the potential for collateral (initial margin) to decline significantly in value over the close out period.
4.2 A central counterparty should identify sources of credit risk, routinely measure and monitor credit exposures, and use appropriate risk management tools to control these risks. To assist in this process, a central counterparty should ensure it has the capacity to calculate exposures to participants on a timely basis as required, and to receive and review timely and accurate information on participants' credit standing.
4.2.1 A central counterparty should frequently and regularly measure and monitor its credit risks throughout the day using timely information. A central counterparty should ensure that it has access to adequate information to allow it to measure and monitor its current and potential future exposures, including to individual participants. Current exposure is relatively straightforward to measure and monitor when relevant market prices are readily available. Potential future exposure is typically more challenging to measure and monitor and usually requires modelling and estimation of possible future market price developments and other variables and conditions, as well as specifying an appropriate time horizon for the close out of defaulted positions. In order to estimate the potential future exposures that could result from participant defaults, a central counterparty should identify risk factors and monitor potential market developments and conditions that could affect the size and likelihood of its losses in the close out of a defaulting participant's positions. A central counterparty should regularly monitor the existence of large exposures to its participants and, where appropriate, their customers. A central counterparty's systems should be capable of calculating exposures to participants intraday and at short notice.
4.2.2 Additionally, a central counterparty should have the capacity to monitor any changes in the creditworthiness of its participants through the systematic review of timely information on financial standing, business activities and profile, and potential interdependencies. The central counterparty should use this capacity to conduct periodic reviews of its participants' credit standing, and to conduct ad hoc reviews where the central counterparty has reason to believe that a participant's credit standing may deteriorate.
4.2.3 A central counterparty should mitigate its credit risk to the extent possible. For example, to control the build-up of current exposures, a central counterparty should require that open positions be marked to market and that each participant pay funds, typically in the form of variation margin, to cover any loss in its positions' net value at least daily; such a requirement limits the accumulation of current exposures and therefore mitigates potential future exposures. In addition, a central counterparty should have the authority and operational capacity to make intraday margin calls, both scheduled and unscheduled, from participants. Further, a central counterparty may in some cases choose to place limits on credit exposures, even where these are collateralised. Limits on concentrations of positions or additional collateral requirements may also be warranted.
4.2.4 A central counterparty typically uses a sequence of prefunded financial resources, often referred to as a ‘waterfall’, to manage its losses caused by participant defaults. The waterfall may include a defaulter's initial margin, the defaulter's contribution to a prefunded default arrangement, a specified portion of the central counterparty's own funds, and other participants' contributions to a prefunded default arrangement.[7] A central counterparty should hold a combination of margin and pooled prefunded resources to control credit risks. Initial margin is used to cover a central counterparty's potential future exposures, as well as current exposures not covered by variation margin, to each participant with a high degree of confidence. However, a central counterparty generally remains exposed to residual risk (or tail risk) if a participant defaults and market conditions concurrently change more than is anticipated in the margin calculations. In such scenarios, a central counterparty's losses may exceed the defaulting participant's posted margin. Although it is not feasible to cover all such tail risks, given the unknown scope of potential losses due to price changes, a central counterparty should maintain additional pooled prefunded financial resources to cover a portion of the tail risk.
4.3 A central counterparty should have the authority to impose activity restrictions or additional credit risk controls on a participant in situations where the central counterparty determines that the participant's credit standing may be in doubt.
4.3.1 If a central counterparty determines that a participant's credit standing may be in doubt, it should have the authority, under its rules and procedures, to impose additional credit risk controls on the participant. These may include placing restrictions on the level or types of activities that the participant can undertake, or calling additional margin or collateral from the participant. In extreme cases, the central counterparty may need to consider suspending the participant (see CCP Standard 12 on participant default rules and procedures and CCP Standard 17 on access and participation requirements).
4.4 A central counterparty should cover its current and potential future exposures to each participant fully with a high degree of confidence using margin and other prefunded financial resources (see CCP Standard 5 on collateral and CCP Standard 6 on margin). In addition, a central counterparty that is involved in activities with a more complex risk profile or that is systemically important in multiple jurisdictions should maintain additional financial resources to cover a wide range of potential stress scenarios that should include, but not be limited to, the default of the two participants and their affiliates that would potentially cause the largest aggregate credit exposure for the central counterparty in extreme but plausible market conditions. All other central counterparties should maintain additional financial resources sufficient to cover a wide range of potential stress scenarios that should include, but not be limited to, the default of the participant and its affiliates that would potentially cause the largest aggregate credit exposure for the central counterparty in extreme but plausible market conditions. In all cases, a central counterparty should document its supporting rationale for, and should have appropriate governance arrangements relating to, the amount of total financial resources it maintains.
4.4.1 A central counterparty should cover its current and potential future exposures to each participant fully with a high degree of confidence using margin and other prefunded financial resources. As discussed more fully in CCP Standard 6 on margin, a central counterparty should establish initial margin requirements that are commensurate with the risks of each product and portfolio. Initial margin should be designed to meet an established single-tailed confidence level of at least 99 per cent of the estimated distribution of future exposure.[8] For a central counterparty that calculates margin at the portfolio level, this Standard applies to the distribution of future exposure of each portfolio. For a central counterparty that calculates margin at more granular levels, such as at the sub-portfolio level or product level, the Standard should be met for the corresponding distributions of future exposure.
4.4.2 In addition to fully covering its current and potential future exposures, a central counterparty should maintain additional financial resources sufficient to cover a wide range of potential stress scenarios involving extreme but plausible market conditions. Specifically, a central counterparty that is involved in activities with a more complex risk profile (such as clearing financial instruments that are characterised by discrete jump-to-default price changes or that are highly correlated with potential participant defaults) or that is systemically important in multiple jurisdictions, should maintain additional financial resources sufficient to cover a wide range of potential stress scenarios that should include, but not be limited to, the default of the two participants and their affiliates that would potentially cause the largest aggregate credit exposure for the central counterparty in extreme but plausible market conditions. Determinations of whether a central counterparty is systemically important in multiple jurisdictions should include consideration of, among other factors: the location of the central counterparty's participants; the aggregate volume and value of transactions that originate in each jurisdiction in which it operates; the proportion of its total volume and value of transactions that originate in each jurisdiction in which it operates; the range of currencies in which the instruments it clears are cleared or settled; any links it has with FMIs located in other jurisdictions; and the extent to which it clears instruments that are subject to mandatory clearing obligations in multiple jurisdictions. All other central counterparties should maintain additional financial resources sufficient to cover a wide range of potential stress scenarios that should include, but not be limited to, the default of the participant and its affiliates that would potentially cause the largest aggregate credit exposure for the central counterparty in extreme but plausible market conditions. In all cases, a central counterparty should document its supporting rationale for, and should have appropriate governance arrangements relating to (see CCP Standard 2 on governance), the amount of total financial resources it maintains.
4.5 A central counterparty should, through rigorous stress testing, determine the amount and regularly test the sufficiency of its total financial resources available in the event of a default or multiple defaults in extreme but plausible market conditions. Stress tests should be performed daily using standard and predetermined parameters and assumptions. On at least a monthly basis, a central counterparty should perform a comprehensive and thorough analysis of stress-testing scenarios, models and underlying parameters and assumptions used to ensure they are appropriate for determining the central counterparty's required level of default protection in light of current and evolving market conditions. A central counterparty should perform this analysis of stress testing more frequently when the products cleared or markets served display high volatility, become less liquid, or when the size or concentration of positions held by a central counterparty's participants increases significantly. A full validation of a central counterparty's risk management model should be performed at least annually.
4.5.1 A central counterparty should determine the amount and regularly test the sufficiency of its total financial resources available in the event of a default or multiple defaults in extreme but plausible market conditions through rigorous stress testing. A central counterparty should also conduct reverse stress tests, as appropriate, to test how severe stress conditions would be covered by its total financial resources. Because initial margin is a key component of a central counterparty's total financial resources, a central counterparty should also test the adequacy of its initial margin requirements and model, through backtesting and sensitivity analysis, respectively (see CCP Standard 6 for further discussion on the testing of initial margin requirements and model).
4.6 In conducting stress testing, a central counterparty should consider the effect of a wide range of relevant stress scenarios in terms of both defaulters' positions and possible price changes in liquidation periods. Scenarios should include relevant peak historic price volatilities, shifts in other market factors such as price determinants and yield curves, multiple defaults over various time horizons, simultaneous pressures in funding and asset markets, and a spectrum of forward-looking stress scenarios in a variety of extreme but plausible market conditions.
4.6.1 In constructing stress scenarios, extreme but plausible conditions should not be considered a fixed set of conditions, but rather, conditions that evolve. Stress tests should, on a timely basis, incorporate emerging risks and changes in market assumptions (for example, departures from usual patterns of co-movements in prices among the products a central counterparty clears).[9] A central counterparty proposing to clear new products should consider movements in prices of any relevant related products.
4.6.2 A central counterparty should also conduct, as appropriate, reverse stress tests aimed at identifying the extreme scenarios and market conditions in which its total financial resources would not provide sufficient coverage of tail risk. Reverse stress tests require a central counterparty to model hypothetical positions and extreme market conditions that may go beyond what are considered extreme but plausible market conditions in order to help understand margin calculations and the sufficiency of financial resources given the underlying assumptions modelled. Modelling very extreme market conditions can help a central counterparty determine the limits of its current model and resources. However, it requires the central counterparty to exercise judgement when modelling different markets and products. A central counterparty should develop hypothetical very extreme scenarios and market conditions tailored to the specific risks of the markets and of the products it serves. Reverse stress testing should be considered a helpful management tool but need not, necessarily, drive the central counterparty's determination of the appropriate level of financial resources.
4.7 A central counterparty should have clearly documented and effective rules and procedures to report stress-test information to appropriate decision-makers and ensure that additional financial resources are obtained on a timely basis in the event that projected stress-test losses exceed available financial resources. Where projected stress-test losses of a single or only a few participants exceed available financial resources, it may be appropriate to increase non-pooled financial resources; otherwise, where projected stress-test losses are frequent and consistently widely dispersed across participants, clear processes should be in place to augment pooled financial resources.
4.7.1 In the event that projected stress-test losses exceed available financial resources, a central counterparty should obtain additional financial resources. The central counterparty should therefore ensure that its rules and procedures support timely action to increase financial resources in these circumstances. The nature of the additional financial resources called may depend on the distribution of projected stress-test losses. If projected stress-test losses exceed available financial resources for only a single, or few participants, then it may be appropriate to call for additional margin or other non-pooled financial resources from those participants. The central counterparty should clearly articulate the circumstances in which it will call for additional margin or non-pooled financial resources from participants, and both the form (that is, cash or eligible non-cash collateral – see CCP Standard 5) and the time frame in which calls must be satisfied. The central counterparty should periodically engage with participants to ensure that they understand their potential obligations and have taken appropriate steps to ensure that they would be able to meet them. Where projected stress-test losses are consistently widely dispersed across participants, then it may be appropriate for the central counterparty to augment pooled financial resources. The central counterparty should have documented and effective processes in place to achieve this. These processes should clearly specify the circumstances in which additional pooled financial resources may be called, including how any additional contributions from participants are to be determined and when these should be paid.
4.7.2 A central counterparty should have clear procedures to report the results of its stress tests to appropriate decision-makers at the central counterparty and to use these results to evaluate the adequacy of and adjust its total financial resources. Stress scenarios, models and underlying parameters and assumptions should be examined based on historical data of prices of cleared products and participants' positions and potential developments of these factors under extreme but plausible market conditions in the markets that the central counterparty serves.
4.8 A central counterparty should establish explicit rules and procedures that address fully any credit losses it may face as a result of any individual or combined default among its participants with respect to any of their obligations to the central counterparty. These rules and procedures should address how potentially uncovered credit losses would be allocated, including the repayment of any funds a central counterparty may borrow from liquidity providers. These rules and procedures should also indicate the central counterparty's process to replenish any financial resources that the central counterparty may employ during a stress event, so that the central counterparty can continue to operate in a safe and sound manner.
Use of financial resources
4.8.1 The rules of a central counterparty should expressly set out the waterfall, including the circumstances in which specific resources of the central counterparty can be used in a participant default (see CCP Standard 12 on participant default rules and procedures and CCP Standard 20 on disclosure of rules, key policies and procedures, and market data). For the purposes of this Standard, a central counterparty should not include as ‘available’ to cover credit losses from participant defaults those resources that are needed to cover current operating expenses, potential general business losses, or other losses from ancillary activities in which the central counterparty is engaged (see CCP Standard 1 on legal basis and CCP Standard 14 on general business risk). In addition, if a central counterparty serves multiple markets (either in the same jurisdiction or multiple jurisdictions), its ability to use resources supplied by participants in one market to cover losses from a participant default in another market should have a sound legal basis, be clear to all participants, and avoid significant levels of contagion risk between markets and participants. The design of a central counterparty's stress tests should take into account the extent to which resources are pooled across markets in scenarios involving one or more participant defaults across several markets.
Contingency planning for uncovered credit losses
4.8.2 In certain extreme circumstances, the post-liquidation value of the collateral and other financial resources that secure a central counterparty's credit exposures may not be sufficient to cover fully credit losses resulting from those exposures. A central counterparty should analyse and plan for how it would address any uncovered credit losses. A central counterparty should establish explicit rules and procedures that address fully any credit losses it may face as a result of any individual or combined default among its participants with respect to any of their obligations to the central counterparty. These rules and procedures should address how potentially uncovered credit losses would be allocated, including the repayment of any funds a central counterparty may borrow from liquidity providers.[10] A central counterparty's rules and procedures should also indicate its process to replenish any financial resources it may employ during a stress event, so that it can continue to operate in a safe and sound manner.
Footnotes
Current exposure is technically defined as the larger of zero or the market value (or replacement cost) of a transaction or portfolio of transactions within a netting set with a counterparty that would be lost upon the default of the counterparty. [1]
Potential future exposure is technically defined as the maximum exposure estimated to occur at a future point in time at a high level of statistical confidence. Potential future exposure arises from potential fluctuations in the market value of a participant's open positions between the time they are incurred or reset to the current market price and the time they are liquidated or effectively hedged. [2]
In considering any credit exposure to a central bank, on a case-by-case basis a central counterparty may take into account the special characteristics of the central bank. [3]
For example, for a central counterparty that pays and collects variation margin (after marking positions to market and then, upon completion of the variation cycle, resetting the value of positions to zero daily), the current exposure is the difference between the current (that is, at the moment) value of open positions and the value of the positions when the central counterparty last marked them to market for the purpose of collecting variation margin. [4]
For positions that are marked to market and settled daily, potential future exposure is typically related to price development in the interval between the last daily mark to market and the point the position is closed out fully hedged or transferred. [5]
A central counterparty may close out a defaulting participant's positions by entering the market to buy or sell contracts identical but opposite to the net positions held by the defaulting participant at current market prices (see CCP Standard 12 on participant default rules and procedures). The central counterparty may alternatively auction the defaulting participant's positions to other participants whether in whole or in parts. During the liquidation period, market prices on the open positions can change, exposing the central counterparty to additional liquidation costs until the point of close out. To mitigate this risk, a central counterparty may also temporarily hedge the defaulter's positions by entering into positions with values that are negatively correlated with the values of the positions held by the defaulting participant. The central counterparty's liquidation cost therefore not only includes the uncovered current exposure that would exist at the time of default but also the potential future exposure associated with relevant changes in market prices during the liquidation period. [6]
Prefunded default arrangements for loss mutualisation and other pooling-of-resources arrangements involve trade-offs that a central counterparty should carefully assess and balance. For example, a central counterparty may be able to protect itself against defaults in extreme conditions more efficiently using pooled resources, as the costs are shared among participants. The lower cost provides an incentive to increase the available financial resources so that the central counterparty is more financially secure. The pooling of resources, however, also increases the interdependencies among participants. The proportion of assets used to absorb a default that is pooled across participants versus the proportion that is not, such as margins, should balance the safety and soundness of the central counterparty against the increased interdependencies among participants in order to minimise systemic risk. [7]
This concept parallels the technical definition of potential future exposure as a risk measure. [8]
Dependence among exposures as well as between participants and exposures should be considered. If a central counterparty calculates exposures on a portfolio basis, then the dependence of the instruments within participants' portfolios needs to be stressed. [9]
For instance, a central counterparty's rules and procedures might provide the possibility to allocate uncovered credit losses by writing down potentially unrealised gains by non-defaulting participants and the possibility of calling for additional contributions from participants based on the relative size and risk of their portfolios. [10]