Clearing via the Central Counterparty – stability for financial markets

In the event of the default of a Clearing Member, Eurex Clearing AG will perform its proven Default Management Process (DMP). Defaulting Clearing Members that are no longer able to meet their financial obligations create an imbalance from the perspective of the Central Counterparty (CCP), which the default management process is designed to resolve. 

The DMP thus not only ensures the safety and integrity of the capital markets cleared by Eurex Clearing AG, but also protects the non-defaulted Clearing Members from possible negative effects resulting from any default.

The DMP can be summarised in the four following steps:

Eurex Clearing’s settlement process has proven to be very effective during regular exercises and in the settlement of historical defaults. The following conclusions have been drawn:  

1. CCPs are extremely robust and resilient, even under volatile market conditions.
2. The establishment of Eurex Clearing as a multi-asset class CCP has proven to be very efficient. Direct access to electronic exchanges ensures smooth trading. Due to the internal trading expertise that has been built up, the settlement process is independent of external support.
3. Regular fire drills are essential. They ensure that Clearing Member defaults can be settled professionally.
4. The segregation of customer collateral is important to minimise the impact of a failure on end-users and the market.

Possible losses that may result from the default of a Clearing Member, and that exceed the resources of the defaulting Clearing Member, are hedged via a "waterfall" of lines of defense. For the coverage of losses, deposited funds are used in the following order: deposited collateral of the defaulting Clearing Member, the funds provided by the defaulting Clearing Member to the default fund, the contributions of Eurex Clearing to the default fund, as well as the deposited default fund contributions of Clearing Members that have not defaulted.

Yes, this is done through the Eurex Clearing Stress Test. This test checks whether the support mechanisms after a payment default are sufficient to cover the risk position of a defaulting Clearing Member even under the most difficult market conditions. For this purpose, the risk positions of all Clearing Members are tested using a comprehensive scenario catalog for all product types offered.

Basically, the tested scenarios can be divided into three categories:

• Historical scenarios in which market movements observed in the past are simulated
• Hypothetical scenarios calibrated to reflect extreme but plausible future market movements
• Analysis scenarios that are modeled purposefully to support risk management

>> Default Waterfall

The scenarios and procedures used for the stress test are regularly reviewed and applied to all positions of each Clearing Member. The extent to which the default fund is used up by the results of the theoretical stress test calculations is determined daily. If the financial resources from the default fund required to cover losses from the default of a Clearing Member exceed certain benchmarks, the default fund is reduced by the amount of the default, the Executive Board of Eurex Clearing shall decide on risk-minimizing measures such as margin calls or the replenishment of the default fund through additional contributions by all participants.

Eurex Clearing Prisma is a margin calculation method that focuses on the portfolio. This enables portfolio margining within an asset class, as well as cross margining across asset classes, e.g. between listed interest rate derivatives and OTC swaps cleared by Eurex Clearing.

The methodology is based on the consideration of the overall portfolio of each Clearing Member. In contrast to a product-based approach, this has the advantage of taking hedging and cross-correlation effects into account by determining the margin requirement at portfolio level. The risks are calculated across the markets and trading venues cleared by Eurex Clearing for products that have similar risk characteristics. The use of cross-product scenarios allows for a consistent consideration of portfolio correlations and diversification effects.
The model components have been designed to ensure that the risk calculation is based on the standards of accuracy and stability, thus ensuring that the risk model can withstand shocks and changes in the financial markets and adapt dynamically to changes in the risk environment.

The core features of Eurex Clearing Prisma benefit Clearing Members, their customers and the clearing house equally: 

High capital efficiency: Portfolio-based approach allows the consideration of portfolio correlations and diversification effects within listed and between listed and OTC transactions

High accuracy: Cross-product risk factor scenarios allow for the accurate and consistent determination of portfolio correlation and diversification effects.

Robustness: Model components are designed with stability and precision in mind in order to determine appropriate margin requirements in all market situations.

Overarching framework: Consistent risk and default management process for listed and OTC products

Clearing houses can make a significant contribution to minimising transaction risks. For this reason, in the wake of the financial crisis, supervisory authorities introduced mandatory central clearing not only for on-exchange, but increasingly also for off-exchange "over-the-counter" transactions.

This is done through the so-called "novation", where the Central Counterparty enters after a trade between two parties has already been concluded. In this case, the transaction itself has taken place elsewhere, but payment and delivery are made through a central office.

In addition, for transactions that cannot be carried out through clearing houses, supervisors will seek to implement some of the risk mitigation measures described above. This applies in particular to the requirement that both parties to a transaction be required to provide collateral for default (initial margin and variation margin) – and to put it in a separate account.

The European Central Bank and the EU Commission want euro clearing to take place within the EU. Otherwise, central banks and regulators would not have any "opportunity to intervene".
But the market also demands a liquid EU-based alternative for OTC interest rate clearing. With OTC Clear, Eurex Clearing offers a liquid alternative to clearing euro-denominated interest rate swaps - same spread, lowest refinancing costs and EU-based.

Mainly thanks to the partnership programme launched at the beginning of 2018, a strong liquidity pool has been built up for the clearing of euro-denominated interest rate derivatives. This market-led initiative aims to further accelerate the development of a liquid, EU-wide alternative for the clearing of OTC interest rate derivatives. This will benefit customers and the wider market through greater choice and competition, improved price transparency and reduced concentration risk. More than 330 customers currently use the service, 200 more than in 2019.
 
At the end of 2019, DekaBank, the Sparkassen-Finanzgruppe’s securities house, successfully transferred a substantial part of its swap book from the London clearing house LCH to Eurex Clearing in Frankfurt in a single day. The complex transaction with thousands of individual items and a merchant bank as transfer agent was executed without any interruption or market impact.

By extending its OTC clearing services to Japan, Eurex Clearing is opening further access channels to its service. Japanese banks now also benefit from a one-stop-shop for euro-denominated and OTC business.