Our Risk Management Philosophy
At ForexClear, we think of our clearing house as a castle - a fortress protected by numerous ramparts. Should one defensive position be breached, several more walls stand behind it to maintain the safety and stability of the Clearing Members & Clients within.
These various layers of protection are our risk management framework, a series of interlocking defensive barriers that work in concert to protect your cleared trades and the collateral posted against them.
We have designed state-of-the-art safeguards to protect our Clearing Members and their clients, not to mention the stability of the global financial system.
Risk management is at the core of everything we do at ForexClear. Even before we agree to admit a new entity as a Clearing Member, we are scrutinizing it to ensure it has the capabilities to meet our exacting risk management standards.
That philosophy runs right through every step of the clearing process at our CCP and all the way to the settlement of a Clearing Member default. Let us explain our process in a little more detail.
The Details
Membership criteria
As our first line of defence, ForexClear sets stringent and transparent eligibility requirements for prospective Clearing Members. A candidate for membership must demonstrate that it has the necessary expertise and competencies to appropriately value, risk manage and default manage cleared trades.
Fire drills
Once admitted to ForexClear, Clearing Members must participate in periodic fire drills to continually validate their operational readiness. This involves simulating a default to test Clearing Members ability to participate in a resolution, ensuring that our Clearing Members are kept constantly on their toes.
Initial margin
As members and clients clear trades, ForexClear collects initial margin from them to cover potential losses in the event of a default. We calculate initial margin using a historical simulation expected shortfall methodology, which uses ten years of historical market data to estimate the potential loss distribution. We also apply margin add-ons covering credit risk, liquidity risk and sovereign risk where particular Clearing Member’s & clients inherent risk exposure is not captured within the initial margin model.
Variation margin
In addition to initial margin, we also calculate daily variation margin from all counterparties to account for changes in the mark-to-market value of cleared trades. By calculating variation margin we ensure that Clearing Members and clients are current on all obligations which prevent default scenarios where Clearing Member or client losses may have accumulated over a prolonged period of time.
Default management
In the event of a Clearing Member default, these pre-emptive safeguards dramatically limit the impact arising from the failure. Since all positions are collateralised, losses borne by counterparties facing the defaulting Clearing Member are limited. This in turn makes ForexClear’s task of porting trades facing the defaulting Clearing Member to healthy counterparties vastly easier.
Default fund
Following a Clearing Member default, our default waterfall model dictates that the defaulting Clearing Member’s posted margin collateral and default fund contributions are the first resources to be consumed in the resolution. Only after these resources are exhausted and LCH’s own skin-in-the-game is consumed would non-defaulting Clearing Members be exposed to losses.
Default Management Process
No clearing house wishes to see any of its Clearing Members default. If the worst was to happen, however, ForexClear Clearing Members can rest assured that our tried and tested default management process will facilitate an orderly and efficient resolution of the defaulting Clearing Member’s portfolio, including porting of underlying client positions to other Clearing Members in the first instance.
The resilience of the LCH default management process was demonstrated in 2008 when SwapClear resolved Lehman Brothers’ $9 trillion interest rate swap portfolio without inflicting losses on any other Clearing Member.
LCH has further refined and improved the sophistication of our default methodology in the years since. ForexClear’s default management process is built on the same foundation as the SwapClear methodology that proved so robust in 2008.
Our default management process follows three steps to reduce the risk of the defaulting Clearing Member’s outstanding positions without impacting other non-defaulting Clearing Members:
Risk neutralisation & client porting
After a Clearing Member default, ForexClear immediately begins hedging the defaulter’s portfolio via our Default Management Group (DMG), a revolving group of senior executives, foreign exchange traders and risk managers that are seconded to LCH in the event of default.
Where possible, ForexClear will seek to transfer underlying client portfolios to an alternate Clearing Member immediately following a Clearing Member default.
Portfolio auction
Once the risk of the portfolio is reduced to a reasonable level, ForexClear separates the defaulter’s portfolio by currency. The DMG then conducts an auction for each portfolio. The ability to receive and price an auctioned portfolio is one of the criteria we verify prior to granting membership to ForexClear.
Loss attribution
In the event that losses are greater than the financial resources of the defaulting Clearing Member, the funded Default Fund contributions of solvent ForexClear Clearing Members are attributed into tranches based on bidding behaviour in the auction to determine how Clearing Members’ Default Fund contributions will be used in resolving the defaulted portfolio:
Tranche 1 – Non-Bidders
Tranche 2 – Auction Bidders (except winning bidder)
Tranche 3 – Auction Winner (plus those with same bid as winner)
Tranche 4 – Other contributions
ForexClear’s Default Waterfall
ForexClear’s default waterfall establishes the order in which the financial resources of defaulted Clearing Members, solvent Clearing Members and the resources of LCH are consumed during a default resolution.
A defaulting Clearing Member’s posted initial margin is the first asset to be consumed in managing the default, followed by the defaulter’s contribution to the ForexClear Default Fund.
If these assets prove insufficient to resolve the default, LCH’s own capital is next in line for losses. It is only after all of these resources are exhausted that Default Fund contributions from non-defaulting Clearing Members are utilised.