The Bank of England announced on Nov. 17 that three leading derivatives clearinghouses will hold a coordinated exercise in the first half of next year to test their procedures for managing a clearing member default. The exercise, which is still in the planning stages, will involve CME Group, Eurex and LCH.Clearnet and will simulate the effects of a default of a clearing firm that affects all three clearinghouses. Regulators in the U.S., Germany and the U.K. will monitor the exercise, discuss the results, and use the findings to strengthen the clearing system's capacity to manage a default.
David Bailey, director of financial markets infrastructure supervision at the Bank of England, described the plan during a Nov. 17 meeting of the Commodity Futures Trading Commission's Market Risk Advisory Committee, a panel of industry experts that has been examining default management issues. Bailey explained that individual clearinghouses currently conduct "fire drills" on a regular basis to test their own procedures, but a drill involving multiple clearinghouses can provide a more realistic simulation of a major default, given that the consequences of such a default would hit multiple clearinghouses simultaneously.
Earlier this year Eurex and LCH.Clearnet conducted separate but parallel fire drills that assumed a default of a firm that cleared interest rate futures and swaps at both clearinghouses. U.K. and German regulators monitored the exercise, and Bailey said it revealed certain weaknesses, notably variations in the auction file formats used by the clearinghouses and limitations in the ability of clearing members to process auction files from more than one clearinghouse at the same time. These issues are a matter of concern to the regulators, Bailey explained, because in a default scenario the other members of the clearinghouses will need to quickly assess the positions contained in these auction files, determine the amount of risk, and submit bids for those positions in a timely fashion.
The 2017 exercise will expand on the 2016 fire drill by bringing CME into the process, Bailey said. The focus of the exercise will be on the clearing of interest rate swaps, and the addition of CME will mean that the exercise covers most of that market, he added. The exercise will test hedging and auctioning procedures at the three clearinghouses, and possibly also the capacity to port client positions and collateral out of the defaulting firm, another important dimension of default management. Four regulatory agencies are involved in this project: Bafin and the Bundesbank, which oversee Eurex; the Bank of England, which oversees LCH.Clearnet; and the CFTC, which oversees CME.
