LO 76.4: Explain how liquidity of clearing members and liquidity resources of

LO 76.4: Explain how liquidity of clearing members and liquidity resources of CCPs affect risk management and financial stability.
CCPs hold mostly liquid and low-risk assets on their balance sheets, thereby requiring very little capital to guard against insolvency risk. The corresponding liabilities are short-term and mainly represent margin balances owed to clearing members. Assuming no member defaults, CCPs receive margin and default fund contributions from members. The CCPs role is to redistribute variation margin payments from members with negative balances to
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those with positive balances; the net impact to the CCP should be zero. Losses that arise due to the default of a clearing member will only impact a CCP to the extent that the CCP must make payments to the defaulted counterparties. Therefore, such cash payments represent a potential liquidity risk for CCPs, which should be its primary concern from a risk management perspective. In that regard, insolvency risk and capital sufficiency for CCPs are far less relevant.
CCP Loss Sequence
A CCP has the following liquidity resources to cover potential losses should a clearing member default (in the following sequence): 1.
Initial margin’. The initial margin paid to the CCP by each clearing member is used to cover only the direct losses incurred from the members default.
2. Default contribution o f defaulting member. Losses greater than the initial margin may be
covered by the defaulting members default fund contribution.
3. Mutualization o f large losses: Losses greater than #1 and #2 combined are first covered by a maximum contribution by the CCP (skin-in-the-game) to cover the remaining loss. If the skin-in-the-game is not enough, then the remaining losses are covered by other members default contributions.
4. Recovery: Should the entire default fund be insufficient to cover the losses, the CCP
could request additional default fund contributions by non-defaulting members, usually limited to the amount of the initial contribution to the default fund. Another source of funds for CCPs is variation margin haircutting (VMGH), which involves CCPs collecting variation margin payments from members with negative balances but keeping a specified percentage to boost its liquidity resources and transferring only the remaining amount to the counterparties.
3. Failure resolution’. May occur if the CCP is unable to recover sufficient funds or if the
CCP or its members do not attempt to go through the recovery provisions.
The loss allocation process (or loss waterfall) is illustrated in Figure 2.
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Figure 2: Process of Loss Allocation Upon Default of a Clearing Member
Liquidation cost in excess of margin + DF of defaulting member
Failure resolution
Recovery provisions:
Default fund assessments, VMGH
CCP contribution: Skin in the game
Default fund
CCP contribution: Skin in the game
Mutualization of loss across non-defaulted
Clearing Member Clearing Member Clearing Member Clearing Member
Default Fund Contribution
Default Fund Contribution
Default Fund Contribution
Default Fund Contribution
Source: Chart 3: Loss Waterfall: Allocation of Losses in the Event of a Clearing Member Default. Reprinted from Rama Cont, Central Clearing and Risk Transformation, Norges Bank Research, March 2017, 9.
Margin Requirements and Liquidation Costs
Initial margins cover losses as the first step of the sequence just listed. Initial margins are likely calculated based on market risk measures such as standard deviation (SD), value at risk (VaR), or expected shortfall (ES) at a 99% to 99.73% confidence level. The calculation makes use of either: (1) historical data, (2) scenario analysis, or (3) simulation using specific assumptions on relevant risk factors. The risk horizon can be described as the amount of time needed to liquidate a defaulting members positions. That can be anywhere from one day to a few days and is computed based on the asset class being cleared, not the actual portfolio or position.
The CCP may incur a loss based on the clearing members portfolio when the clearing member defaults. Because variation margin would have been provided prior to default, the CCP is only subject to (incremental) liquidation cost, which is the decline in portfolio value between the time of default and the time the portfolio is liquidated. Market risk measures are not effective at capturing liquidation costs because they ignore liquidity, market depth, and bid-ask spread variances between different financial instruments. Additionally, market risk is based on the net position size while liquidation costs are more related to gross notional size.
Liquidation costs can be significant for large positions or concentrated positions. A proper disposition of an unusually large position would often take additional time beyond the stated risk horizon to achieve, therefore resulting in a liquidation horizon that is greater than the risk horizon. As a result, there is a nonlinear relationship between liquidation
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costs and portfolio size. A typical risk measure such as SD, VaR, or ES has a 1:1 linear relationship to portfolio notional size (N). In contrast, the relationship between liquidation cost to position size is N x N 1/2, or N 3/2. For example, if N is doubled, SD, VAR, and ES would double as well but liquidation costs would increase by 2.83 times (23/2).
Proper risk management of CCPs would incorporate a liquidity charge in margin calculations to cover the implied extra costs the CCP would be responsible for when liquidating a defaulted position. The charge would increase for larger position sizes and illiquid assets (illiquid assets are being cleared more frequently nowadays). An accurate liquidity charge may encourage clearing members not to build up concentrated and/or illiquid positions so as to reduce their liquidity risk.
When determining the amount of a CCPs default fund, liquidation costs should be included. The largest clearing members provide the greatest risk to the CCP given that the former would likely engage in transactions that are more difficult to liquidate. Computing the CCPs default exposure should be more detailed and consider increased bid-ask spreads and liquidation costs. Liquidation costs are particularly relevant for large clearing members because liquidation costs are proportional to gross, not net positions.
CCP M e t h o d s f o r Re c o v e r in g Ca pit a l

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