Quick Takes: Default Simulation Exercises by CCPs
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Ali Curi: Hi everyone, and welcome to ION Markets Quick Takes. I'm Ali Curi, and every week, along with my guests, Amir Khwaja and Chris Barnes, we take a quick dive into the headlines on the Clarus blog. Let's get started. 

Amir Khwaja: Hi Ali. 

Ali Curi: Hi Amir. Hi Chris. 

Chris Barnes: Hey Ali, how are you doing? 

Ali Curi: I'm doing great. Welcome back to Quick Takes.

Amir, let's start with you. What are your Quick Takes for this week? Which headline from the Clarus FT blog would you like to discuss? 

Amir Khwaja: Thanks, Ali. It's called "Default Simulation Exercises by CCPs." 

Ali Curi: Okay, sounds good. Let's get started. 

Amir Khwaja: I'll start with, why do CCPs do default simulation? So a CCP, a central counterparty, stands between two traders that do a bilateral derivative, and it's a party to each side of that trade.

It's a CCP, is run by clearinghouse and they're clearing members of the CCP that mutualize risk to make sure that CCP is flat because it's got, it's on both sides of the same trade, but the problem arises if one claim member were to default, then that side has gone, at which point the CCP has market risk.

So it needs to very quickly find somebody else to take over that position, that default. To make sure they're ready to do that, they run these default simulation exercises called fire drills. And that really makes sure that some other member or dealer is able to buy in an auction, the defaulting members portfolio, and nobody else suffers an economic loss.

So I think, the big example in recent history was when Lehman Brothers went bankrupt. I forget when that was now. It seems to be ancient history. 2008, I think. Yeah, or seven. So clearly they defaulted across many CCPs. And the CCPs had to find other clearing members and dealers to take over their positions very quickly in a few days to avoid losses.

So in order to test that, once a year or twice a year, every CCP conducts a drill with its clearing members to make sure they can bid on a portfolio for a defaulting member. And that's the exercise. This year for the first time CCP Global, which is the association of CCPs, has conducted with 31 CCPs an exercise on a concurrent basis, so the same two weeks, 13th November to 23rd November. These 31 CCPs have run a fire drill for all their members. The idea being that, if a large global member defaults, it defaults across many CCPs at the same time. And that puts this burden at the same time on all the members to bid for a portfolio, for many products.

So it makes sense to do it on a concurrent, the same week basis. It makes it much more realistic what would happen with large member defaults. And you want to ensure that there are members there willing to bid in an orderly process. For example, I think there was a, the default at NASDAQ clearing.

They didn't quite follow their rules. The auction, was done very quickly with one, one dealer that bought the portfolio when that power trader defaulted. That wasn't global, that was only on one CCP. Examples are that you need to be able to run regular drills to simulate defaults, make sure it happens in a slick, orderly fashion.

So when a real default happens, There are no surprises, and that's what my blog, really my blog covers the fact that CCP Global, the association of CCP's is now conducting and helping people documenting what happens in these drills. So they happen on a consistent basis at the same time. Same assumptions.

So that's what the blog covers. 

Chris Barnes: Amir, this whole fire drill exercise really fascinates me because back in 2008, I actually had friends in the market who were called into swap clear to execute the default management swap, so for Lehman, right? So you've got this case where swaps desks are a man down because as somebody has moved into the clearing house to actually execute these swaps. 

So something that's really fascinated me about the fire drill process is what are the CCPs trying to achieve exactly? Is it to test the operational readiness of other clearing members to accept 60,000 swaps or 100,000 swaps? Is it to check the initial margins are right? In the case that there is a lot of margin taken on the side of risk, is it that it's just a regulatory tick box exercise that they have to do?

Amir Khwaja: Yeah, good question, Chris. So I would say it's most of those. So firstly, they have to test their own readiness, right? So are they able to take a defaulting members portfolio and repackage it with hedges to make it palatable in an auction? Which is why traders are co-opted into CCP that haven't got exchanges.

If you have an exchange, I guess you can do that yourself. Then to test the member readiness in an auction. And really they have to be efficient. So the faster you can do that within your margin period of risk. So if your IM is a five day margin period of risk loss, you want to make sure you can sell it within five days, ideally because you would incur less than five days of market loss, right?

And then the defaulting members, IM should be sufficient to cover their losses without drawing on other members contributions, right? So clearly, so I think in the Lehman's case for SwapClear, there were sufficient, Lehman's. But I think in the case of Einar Aas at the Nasdaq Clearing Power markets, his margin wasn't sufficient. So other members did incur significant loss, I think, on their default fund contributions, which are very expensive, right? So I think, so there's that, and I think as, I think a third point about, governance, as CCPs get larger and larger, systemic, more things are cleared.

It's important that, they're able to conduct these governance exercises in the event of default, efficiently. 

Chris Barnes: And we've been involved now in a lot of the fire drills. How many swaps are you talking about? How big are these? 

Amir Khwaja: Oh, swap markets, yeah. So I would say we've done, I don't know how many years now more than eight, nine years, semi annual drills. So because swap portfolios, unlike futures positions, are individual trades. There's going to be very large portfolios. A defaulting dollar member for a large clearing house can have 40,000 swaps, right? To load those into your systems is non trivial for members to provide bids.

So the more software, the more automation, both on the CCP side and the member side, be able to quickly upload large packs of trades, to value them accurately, to assess the risk, to get different perspective on the fair value of that pack for making a bid. And it's, it's harder on, on OT Derivatives because every trade, is a contract, but equally on, on futures there's so many different contracts, right?

If you're in commodity markets or you're doing options, there are large number of strikes and large number of series, right? So you have to be very efficient to be able to upload the pack of positions and value them in a stressed market where there's a default happening. 

Chris Barnes: And that example of 40,000 swaps, is that across all of the 27 cleared currencies, or is 40,000 only for the dollar portion of the Firedrill split? 

Amir Khwaja: So normally to make them palatable, at least on, on rates, people split the packs by currencies. The idea being that someone will pay for a currency because they have some interest in that currency. It might be a domestic currency. They always pay by currency, but not for client defaults.

Client packed defaults are more multi currency, so people can pay for those, right? It's a nice way to segment, really by making palatable in an auction, right? So in futures, you might split in a different way, by market, et cetera. 

Chris Barnes: And thinking about in recent times, the most parallel market event that we've seen to a real life default would probably be the auctions that were run when CME and LCH converted from Fed Funds discounting to SOFR.

And there was that large amount of market risk that, that had to go through as Fed Funds SOFR basis. I remember looking back then at typical sizes. And the auction pack was 11,000,000 dollars of O1 in gross risk. It was 8,000,000 of DV01 in net risk, massive numbers. As a trader, you might be asked to bid on a million dollars of DV01 as a very big client trade, asking to provide a price on that type of size is pretty much unheard of. I imagine some of the Firedrill packs have even larger positions than that. 

Amir Khwaja: Yeah, they can do. I think, they try and hedge them, but yes, there is a large amount of risk. It's not like making a price on a swap to a client or an inter dealer swap. You have to really assess a large portfolio.

But again, there's ppportunity for portfolio traders that are used to buying portfolios and the opportunities to do well. 

Chris Barnes: And I guess the point is if you can process that pact from the CCP as quickly as possible, then you are the one that sees the auction first. You are aware of the risk and what has got to go through the market.

Amir Khwaja: Yeah, exactly. And to me, it's all about, as they become more concurrent, these drills and more consistent, more automation is needed both at the CCPs and at the clearing members to efficiently run an auction for a default to be successful within a defaulting members IM. 

Chris Barnes: Thanks man. 

Amir Khwaja: Great, Ali. So that covers the blog.

It's called "Default Simulation Exercises by CCPs." 

Ali Curi: Great. Thank you, Amir. And thank you for sharing with us the title of your blog post. 

Amir, Chris, thank you both for sharing your Quick Takes. Let's do it again next week. 

Amir Khwaja: Thank you, Ali. 

Chris Barnes: Thanks, Ali. Looking forward to it. 

Ali Curi: And that's our episode for today. You can read more about these topics on the Clarus blog, and you can follow ION Markets on X and on LinkedIn.

Chris Barnes: Until next week, thank you for joining us.