Account for the ways losses are absorbed and the default of one or more CCP members is handled.
The idea
When a member defaults, the CCP declares default and hedges the market risk of the portfolio. It then auctions or closes out the positions, often to surviving members, to return to a matched book. Client positions may be ported to another member. Losses are absorbed through the waterfall: the defaulter's margin and fund contribution, then CCP capital, then surviving members' contributions. If these are exhausted, recovery tools apply. Assessments call for more cash, usually capped as a multiple of contribution and shared pro rata. Variation margin gains haircutting cuts payouts to members with gains, pro rata to the shortfall. Partial tear-up terminates contracts at the last price instead of paying cash. Haircutting leaves positions in place, while tear-up removes them and leaves members to rehedge. The exam point is that recovery tools sit after pre-funded resources and the order matters.
Formulas
Variation margin gains haircut rate
Haircut rate = Shortfall ÷ Total gains
- Shortfall
- the loss left after all pre-funded resources are used
- Total gains
- the variation margin owed to all members with gains
Each winner loses this share of its gains, pro rata, not an equal slice. Positions stay in place; only the cash paid out is cut.
A practice question
What does a CCP typically do first with a defaulted member's portfolio?
- Hedge its market risk, then close out or auction the positions, often to surviving members, to return to a matched book. - correct
- Hold the portfolio unhedged to maturity and pass the net payments through to the surviving members as they fall due, avoiding any forced sale.Why not: Leaves the CCP exposed to market risk during a stress period.
- Terminate all contracts at the last price and mutualise the difference immediately.Why not: Skips hedging and auction, which come first; termination is a recovery tool of last resort.
- Transfer all positions to the largest member at no cost to that member.Why not: Invents a free transfer; positions are auctioned at a price that reflects their value and risk.
The priority is a quick return to a matched book: hedge the risk, then auction or close out the positions, with losses met through the waterfall.
A harder one
After all pre-funded resources are exhausted, a CCP faces a shortfall of USD 50 million. Four members are owed variation margin gains of USD 400 million in total, and one of them is owed USD 80 million. If the CCP uses variation margin gains haircutting pro rata to gains, that member receives:
- USD 30.0 millionWhy not: Assumes the member bears the whole shortfall instead of its pro rata share.
- USD 67.5 millionWhy not: Splits the shortfall equally among the four members (12.5 each) rather than pro rata to gains.
- USD 70.0 million - correct
- USD 80.0 millionWhy not: Assumes the variation margin gains are always paid in full.
Haircut = 50/400 = 12.5% of gains. The member bears 80 x 0.125 = 10 and receives 80 - 10 = USD 70.0 million.
The hardest tier
After the survivors' default fund is used, a shortfall of USD 120 million remains. Four surviving members have default fund contributions of USD 40 million, 40 million, 60 million and 60 million, and the rules allow assessments up to each member's contribution, shared pro rata to contributions. The first member (USD 40 million) is assessed:
- USD 40 millionWhy not: Applies the full cap, although the shortfall is only 60% of the total assessment capacity.
- USD 24 million - correct
- USD 30 millionWhy not: Splits the shortfall equally among the four members.
- USD 12 millionWhy not: Uses a denominator of 400, counting both the contributions and the assessment caps.
Assessment capacity = 200. Pro rata share = 40/200 = 20%, so the member pays 120 x 0.20 = USD 24 million, within its cap of 40.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Central Clearing
- State what a central counterparty (CCP) is and outline how central clearing works.
- Account for novation as it applies in central clearing.
- Explain multilateral offset, compression and netting, illustrating each with a case.
- Outline how margin and default funds are applied and estimated under central clearing.
- Discuss the exposures a CCP bears and how it controls them.
- Show a loss waterfall at work through illustrations.
- Contrast clearing done bilaterally with clearing done through a central counterparty.
- Contrast the initial margin and default fund contributions asked of clearing members, with respect to how losses are covered, what clearing costs and the moral hazard created.
- Outline the strengths and weaknesses of central clearing.