Despite the disruption and the volatility created by the pandemic, clearinghouses were extremely well prepared, EACH and LCH explain more
Clearinghouses have to operate in the stormiest of seas. They must be reliable and resilient. In the aftermath of the financial crisis of 2007/2008, the industry continues to work towards greater transparency. In line with this, new stringent regulations have been introduced, and as part of this new ‘ecosystem’, clearinghouses play a fundamental role to ensure market stability.
Clearinghouses facilitate the exchange of payments, securities or derivatives transactions. The clearing house sits in between two clearing firms and reduces the risk of a member firm failing to honour its trade settlement obligations.
COVID-19 marked the first real test of the ‘new ecosystem’ since the financial crisis and experts say they behaved remarkably well.
Daniel Maguire, group director of post trade at LSEG and Group CEO of LCH, comments: “The market volatility of March 2020 was a stern test of market infrastructure and central counterparty (CCP) margin models. On the whole, financial market infrastructure performed well during this period. LCH did not adjust or change any margin models and processes. These remained consistent throughout the period of volatility in March 2020.”
Over at the European Association of CCP Clearing Houses (EACH), secretary general Rafael Plata remarks: “Clearinghouses coped very well. Looking at the small niche of our market, and the importance clearinghouses play in preserving stability for the whole economy — this has been the best quality seal that CCPs could get.”
EACH’s policy adviser Elena Tonetto adds: “Within EACH we prepared a short paper with feedback from our members and now we are updating this work. At the Secretariat we really want to understand how our members coped. The feedback we received was very good, and it is clear they coped very well.”
Stormy weather
When large volumes of volatility struck the markets in March and April last year, the main priority for the clearinghouse was to ensure financial stability by absolving risk.
For example, at LCH, the British clearing house group that serves major international exchanges, as well as a range of over the counter markets, the priorities were about ensuring financial stability and maintaining orderly functioning of markets.
While CCPs’ models were tested during market volatility, market infrastructure and the cleared derivatives markets performed well on the whole, according to LCH.
In terms of specific challenges, Plata suggests that while there were large volumes of volatility, CCPs did not face major challenges because they have been working on operational resilience for a long time and so were well prepared for the events that ensued with the pandemic.
Many clearinghouses had already made heavy investments in operational resilience.
However, margin requests soared during the initial phases of the pandemic and clearing. There was a lot of variation in margin requests from clearing members as they had to adjust to all these spikes in the market.
“Some CCPs had to deal with several times the normal amount of variation margin requests that they would ordinarily have in a day. This means that in terms of processes, it was much more intense. This was challenging to clearing members due to the volumes but ultimately margin calls were met,” says Plata.
EACH had larger than ever daily index drops in France, Italy and Spain while Germany and the UK had the second-largest fall ever on indexes.
Plata explains the circumstances were extremely unprecedented because of the huge market moves that coincided with the fact that most CCPs had to work in business continuity mode, which means that most of them had to work from either their recovery site, from home or split the staff. In most cases, there was a splitting of the staff in several locations.
CCPs have a secondary location in case something goes wrong with the first location in the headquarters, they need to be able to run the operations somewhere else. With the pandemic, CCPs used different possibilities in their business continuity plans to minimise operational risk, according to Plata.
Plata comments: “As such, people were working from the office, people were working from home and others were working in the backup locations.”
In addition to the market volatility, clearinghouses also had to deal with the unprecedented circumstance of working in business continuity mode for such a long time. With the pandemic still ongoing, CCPs are continuing to work in this mode despite the fact it is almost one year after the event.
EACH’s June 2020 survey asked two main questions among its members: how did CCPs cope with the anti procyclicality rules (so whether this rule proved to be useful and strong); and second, whether they identified any issues in the management of the risk and margins.
“In both cases, the responses were very positive so it was found that CCPs did not have issues in complying with anti procyclicality rules that are included in the European Market Infrastructure Regime (EMIR) regulation. This is the best test the CCPs and legislation could go through in terms of this, so EMIR really proved to deliver its objective,” says Tonetto.
On the management of risk and margins, EACH participants also noted that they did not find any particular issues. The little difficulties that were encountered were included in risk tolerance, according to the association.
In terms of specific challenges, Plata says: “What we are hearing from CCPs is that this was all in their plans, they rehearsed this business continuity mode from time to time — they must do it according to the legislation in the European law. So the only new thing that they didn’t expect was that they had to stay at home for so long and deal with all of the issues that all of us are dealing with in terms of human resources, checking employees well being, etc. But other than that there was no huge challenge, and in a way it was business as usual. Market volatility and business continuity were dealt with well. It was truly all hands on deck.”
All hands on deck
By being well prepared and resilient, clearinghouses did not need to open or closer later or earlier. For example, LCH did not change its hours of operation, nor adjust or change any margin models or processes, which remained consistent and performed well throughout the pre- and post-March 2020 period of volatility.
As well as dealing with the impacts from the pandemic, EACH had to run a business continuity mode in June. This came after the European Securities and Markets Authorities (ESMA) contacted EACH’s CCPs saying they wanted to run a business continuity mode on all of the CPPs.
ESMA wanted to ensure CCPs could cope with anything that could occur in relation to default in business continuity mode, and since the CCPs were in business continuity mode at the same time, ESMA wanted to strike while the iron was hot. Eventually, this was performed in June because of the time it took to prepare. Plata says the conclusion was great as ESMA confirmed that everything worked perfectly.
Plata comments: “So this test was very successful and they were able to deal with defaults from clearing members working from home in business continuity mode. From the operational resilience point of view from a CCP, this was another quality seal on CCPs.”
According to Plata, this created an overall sense of comfort for the authorities who acknowledged the work of CCPs during the turmoil and also from an operational resilience point of view.
LCH’s Maguire notes: “Operational resilience is a fundamental part of our culture and remains an important area of focus and our systems across all asset classes performed as expected during the volatility in March.”
By way of example, LCH’s EquityClear service went live in March with a new post-trade platform provided by LSEG Technology. The platform successfully processed EquityClear’s largest ever volumes processed with nearly 80 million trade sides cleared in the first five days of operation in March 2020.
Smooth sailing?
Although the evidence shows the industry worked well to deal with the pandemic, there have been some critics. There is an argument that one of the reasons for the large margin calls observed during the March events is that margin models ‘seem to have underestimated market volatility, in part because they have relied on a short period of historical price movements from tranquil times’. It was suggested that CCPs had to catch up and increase margins at the wrong time, squeezing liquidity when it was most needed.
The World Federation of Exchanges recently published a paper suggesting that CCPs and exchanges could not have prevented the COVID-19 related spikes in margin requirements.
Weighing on this, Maguire says: “The March 2020 market volatility showed that LCH’s risk models performed as designed, with no adjustment required to accommodate the heightened volatility: there were no ‘spikes’ in margin.”
Crucially, Maguire highlights that a significant percentage of the collateral increase in LCH CCPs was derived from new risk positions, rather than additional collateral being called against existing positions.
According to Maguire, this demonstrates the importance of setting initial margin requirements conservatively at all times and having margin floors, rather than tailoring them to specific market conditions.
While anti procyclicality buffers are included in European legislation, and currently still in the UK legislation, they mean that CCPs do not have to ask for too much margin during spike times or too little in normal times. Those buffers do not exist everywhere in the world.
Plata suggests that one good thing going forward would be to analyse these buffers and identify how well they worked and look at if there is anything that can be done to improve this in order to smooth out the impact of margin requests because margin requests are going to be there if there is huge volatility in the market.
“Work that is done here needs to look at the overall market, not just by pointing at one or the other, it is looking at the interaction of every part of the market: the CCP to the clearing member, the clearing member to the end client, and the central banks and government,” comments Plata.
Experts say this is something that should be looked into going forward.
Overall, Plata believes the industry as a whole is working well together to combat challenges. EACH is in almost daily contact with colleagues at clearing members associations such as the International Swaps and Derivatives Association (ISDA), they also represent some of the clients (for example, asset managers and investment funds).
LCH’s Maguire adds: “We welcome further dialogue and collaboration in the industry on how best to reduce systemic risk and improve financial stability.”
“We continue to work closely with policymakers, regulators, CCPs, and other market infrastructure providers, clearing members and clients on how to most effectively manage initial margin in all market condition
