How Do Central Clearing Counterparties Fail?

Central clearing counterparties (‘CCPs’) are key institutions for the smooth functioning of modern financial markets. In many markets, after a trade is agreed between two traders, a CCP interposes between them, and becomes a buyer to the seller, and a seller to the buyer. By becoming counterparty to both traders, it insures each of them against the default of the initial counterparty. A CCP is able to provide such insurance by engaging itself in risk management, for example by calling margins (ie, collateral) from traders. The use of CCPs is widely expected to improve financial stability, and post-crisis regulation worldwide mandates the use of CCPs for all standardized derivatives. However, a new risk arises from the use of a CCP: since all counterparties are connected to the CCP, its default could have catastrophic consequences for financial markets and the macroeconomy. While CCP defaults are expected to be rare events, they cannot be ruled out.

In our recent paper ‘The Failure of a Clearinghouse: Empirical Evidence’, we provide the first empirical study of the failure of a CCP: the Caisse de Liquidation des Affaires en Marchandises (CLAM), a CCP operating in the Paris Commodity Exchange, which failed in 1974. We hand-collect archive data to describe its failure, understand its risk management incentives around default, and draw implications for the design of CCPs and of their default management schemes.

The CLAM was the only CCP operating in the Paris Commodity Exchange, a market for cocoa, coffee, and sugar futures, the latter being its most active segment. Between 1973 and 1974, a six-fold increase in global sugar prices spurred trading activities. Starting in November 1974, the collapse of sugar prices triggered margin calls for investors with long future positions, and induced the largest clearing member to default. This default led to a temporary closure of the market, and, ultimately, to the failure and resolution of the CLAM.

Our main finding is that CCP failures do not necessarily follow a sustained period of lenient risk management. Using data on initial margin requirements and on traders’ accounts at the CLAM, we show that risk management by the CCP was strong during the sugar price boom. However, we also find evidence of severe distortions in risk management as soon as sugar prices collapsed and a large clearing member approached distress. In particular, the CLAM failed to declare this member in default early enough, and, consequently, delayed the liquidation of the member’s open position. Furthermore, severe distortions persisted after the default of the clearing member, and during the entire recovery/resolution stage. First, the CLAM strongly supported the temporarily closure of the sugar market, in the hope that it would lead to a settlement price above the market price that then prevailed. Subsequently, the CLAM refused a proposal by sugar professionals to buy the entire position of the defaulted member, which could have allowed the market to quickly reopen. Overall, the CLAM and the defaulting member had aligned interests, at the expense of solvent members.

Theoretically, we show that these distortions are akin to risk-shifting (or gambling for resurrection). If the CLAM had stuck to its standard risk management principles, by calling margins from the member in distress and by liquidating the defaulted position, its loss could have been large enough to drive its equity value to zero. Instead, more leniency vis-à-vis the member in distress was a risky bet that could have preserved its equity value in case of price reversal. We show that these risk-shifting incentives are also important to understand why no negotiated recovery was agreed upon, and why the CLAM ultimately went through an administered resolution procedure. Due to the fact that CCPs are often thinly capitalized relative to their largest potential clearing liabilities, we expect similar risk-shifting incentives to be a more general feature of CCPs near distress.

Our results have a number of important policy implications. First, better capitalized CCPs are desirable to reduce risk-shifting incentives near distress. However, it is unlikely that CCPs can reach capitalization levels that could completely rule out risk-shifting. Improvements in CCP governance could be a useful complement. Finally, we show that the design of default waterfalls (the structure of loss allocation upon the default of a clearing member) can also mitigate risk shifting. In particular, when the CCP’s equity is divided in tranches, as is the case for several modern CCPs, equity holders are not the only residual claimants, but share this role with surviving clearing members. This reduces the sensitivity of a CCP’s equity value to changes in settlement prices, and ultimately reduces the likelihood that misguided decisions are taken near default.

Vincent Bignon is a Senior Expert Economist and Deputy Head of the Microeconomic Analysis Unit of the Banque de France, and Guillaume Vuillemey is Assistant Professor of Finance at HEC Paris.