foreword - fia · pdf file2 fia-foa clearing risk study foreword in september 2007 the futures...

2 FIA-FOA Clearing Risk Study

Foreword

In September 2007 the Futures Industry Association and the Futures and Options Association initiated a study of risk controls in the futures industry to document existing margining and direct market access procedures and policies and to encourage best practices across markets. The study was sponsored by FIA and FOA, CME Group, Eurex Clearing, ICE Clear U.S., LCH.Clearnet, and New York Mercantile Exchange.

The report produced on the basis of the study was scheduled to be released last fall but was delayed while the industry responded to the Lehman bankruptcy. The sponsors considered whether a further delay would be appropriate in order to broaden the scope of the study to include issues arising from that bankruptcy. We concluded that the margining and direct market access principles contained in the report were important practices for the market to embrace at the earliest opportunity, whilst the issues arising from Lehman will continue to emerge and are clearly worthy of separate, extensive consideration. We therefore decided to release the final study at this time.

Many of the issues raised in the Lehman insolvency revolve around customer protection, default management and bankruptcy laws. Although the adequacy of margining is an important factor in effective default management, these issues were not central to the aspects of the study that are the focus of the report. However, a key recommendation of the report is the establishment of a FIA/FOA Risk Management Advisory Committee to oversee the recommended standards, and our intention is to broaden the remit of the committee to consider relevant matters arising from the Lehman default.

We would like to offer thanks to the sponsors and all members of the associations that contributed time and effort to the study, to David Myers and his team at Deloitte for their work in organizing roundtable discussions and sub-groups, and to Andrew Lamb for his general advice and drafting of the report.

Richard Berliand Michael Dawley Steve SparkeActing Co-Chairman Acting Co-Chairman ChairmanFutures Industry Association Futures Industry Association Futures and Options Association

FIA-FOA Clearing Risk Study 3

Contents

FIA-FOA Clearing Risk Study

Foreward. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2

A. Introduction and overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4

B. Process for review of practice against standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

C. Standards for exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8-

D. Standards for clearing houses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12

E. Standards for clearing firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16

Appendix: initial margining – clearing house and clearing firm perspectives . . . . . . . . . . . . . . .18

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19


A. Introduction and overview

An evaluation of risk controls in the futures industry i was initiated by the boards of the Futures Industry Association and the Futures and Options Association in September 2007, with the active support and sponsorship of a group of the largest futures exchanges and clearing organizations in the world ii. The process involved participation from a wide range of broker-clearing firms and exchange and clearing house members of the two associations.

The breadth of participation in the exercise emphasizes both the extent to which the risk protections of the futures industry are a joint effort on the part of exchanges, clearing houses and clearing firms, and the widespread realization of that inter-dependence and mutual reliance.

The evaluation process originally looked at more-or-less the full range of areas of risk and associated risk controls in the industry, led by the more recent experience and analysis of clearing firms. Focus soon concentrated on a small number of key areas. Those areas were tackled through three sub-groups that looked at: the normative control environment for direct market access (DMA) provided by exchanges and issues related to give-ups; data and information required by clearing firms for effective management of client risk; and margining and control of large and concentrated positions.

This report assesses the risks and the then existing risk controls in these key areas, and recommends reviews of current practice against specified standards, taking into account the particularities of membership and account structures in the various markets and arrangements. The level of detail of the standards varies across the key areas, and in some case will need to be refined in the first phase of further work. The most specific standards are advanced for DMA controls, where the FIA had been undertaking work before this evaluation and published a survey of practice in December 2007 iii.

If the standards are applicable given the membership and account structures of particular markets and arrangements and are not already met, change to meet the standards will need to be implemented by the three key groups in the inter-dependent risk management approach that has evolved in the futures industry.

- Futures exchanges: are asked to ensure that their provision of open interest and other market information, key to the client risk evaluation of clearing firms, is timely and comprehensive; and to ensure that DMA facilities they provide are accompanied by comprehensive controls ensuring that clearing firms guaranteeing the performance of clients to exchange clearing houses have the information and the ability to establish controls and pre-trading limits that they need for their risk management.


- Clearing houses: are asked to ensure that their risk methodologies, particularly for margining and control of large and concentrated positions, are rigorous and fully explained in their published documentation; and to take measures where possible to assist the risk management of clearing firms.

- Clearing firms: are asked to critically examine their own risk management of clients, strengthened by improved controls and information, and greater transparency, from exchanges and clearing houses, and to take any necessary measures on the basis of their own risk evaluation, appreciating that their risk protections may be more reliant on initial margin than is the case with clearing houses.


B. Process for review of practice against standards and further work

The boards of the FIA and FOA are aware of the low impact of many previous sets of worthy recommendations. They feel optimistic, however, that those offered in this report will not suffer the same fate because of the extensive participation in the work, the fact that the standards and recommendations are specific and focused, and because of the proposed structure for the review of practice against standards and change in response to the standards.

These boards are only too aware of the events that have occurred since the report was largely finalized in mid-2008. While these dramatic events cannot be ignored and further work is indeed planned, they believe that it is in everyone’s best interest to publish the final report now. The recommendations set forth below are based on information acquired in 2007 and early 2008 and the importance of their being addressed with dispatch by the global futures industry is reinforced rather than in any way being superseded by recent events.

The proposed review mechanism is as follows:

(a) The sponsors of the clearing risk study will establish a standing Risk Management Advisory Group (“the Group”), composed of senior executives with significant experience of the industry, to oversee the standards proposed in the clearing study. Membership of the Group will be open to other participants as deemed appropriate. The FIA and FOA will appoint senior representatives from member firms to participate on a rotating basis.

(b) The Group will develop a simple form for exchanges/clearing organizations to use to evaluate their practices against the standards proposed in the clearing study, and to detail any changes that they have or will make in response to the recommendations and the timeline for making those changes. In their evaluations, exchanges/clearing organizations should provide details of any cases in which their membership or account structure and legal or regulatory requirements make the proposed standards inapplicable. These self-evaluations will be available for members to review on the FIA and FOA websites.

(c) On the basis of their review of self-evaluations, and after any necessary dialogue to verify understanding, the Group will notify the boards of FIA and FOA of cases where they believe that practice falls short of the standards and the exchange/clearing organization in question has not indicated a proposal and timetable for change.


(d) The Group will host a Risk Managers’ Roundtable that will meet at least semi-annually to discuss concerns or changes in market practice that impact risk management. Risk managers from firms and clearing organizations representing all major derivatives markets will be invited to participate. The need for changes to the standards in the light of market developments will be discussed at the roundtable meetings.

(e) The proposed standards for clearing firms’ risk management and margining will be circulated to senior management at the firms. Amongst the proposed standards is a recommendation that senior management should, in light of the study, commission reviews of the appropriateness of current practice from their risk managers. Their practice should be reviewed again whenever the adequacy of margin held is tested in the event of client default or failure.

(f) As part of its volume and open interest reports, FIA/Institute for Financial Markets will work with the industry on the feasibility of a standardized methodology for the reporting of open interest data, including the level of disaggregation of the data.


C. Standards for exchanges

(i) Direct market access facilities provided by exchanges

Risk assessment

The prevailing model in all major futures markets is that the trades of non-clearing exchange members and non-member clients of the market must be cleared by clearing members at the linked clearing house. This establishes two distinct layers of counterparty and market risk management. Clearing members are responsible for managing the risk of their clients, with whom the clearing house has no direct legal relationship, and clearing houses are responsible for managing the risk of their clearing members. The default or failure of the client of a clearing member has no immediate risk consequences for the clearing house unless it causes losses that lead to the default or failure of the clearing member.

The management of client risk by clearing firms, and of clearing member risk by clearing houses, has evolved as longer-established exchanges have moved to electronic trading from trading floors, and newer arrivals have adopted electronic trading from their outset. In most respects, the judgment is that risk controls have strengthened.

Running counter to this general strengthening, broker-clearers have pointed out that, while some exchanges offering direct access to non-member clients of the market have provided risk controls and information to enable clearing members to maintain the necessary standards of client risk management, others have not. There is no difference of opinion concerning the desirability of improving the immediacy of market access. The concern is that clearing members are not able to exercise appropriate risk controls and establish pre-trading limits unless the exchanges consult them fully ahead of introducing or expanding and modifying direct market access, and then provide them with the necessary controls and information as an integral part of the improvement of market access. As noted above, the results of client failure arising from excessive trading not sufficiently visible to their clearing firm might have no consequences for a clearing house if the clearing firm remains solvent and tightens its controls. At the same time, exchanges are typically not directly involved in the financial consequences of counterparty failure other than through ownership of clearing houses. However, the provision of controls to help avoid such events must be regarded as a priority of any exchange in order to protect the overall integrity of its marketplace, and in recognition of the risk management role undertaken by clearing members.


Recommended standards to ensure adequate controls and practices

Whilst it is recognized that exchanges’ ability to offer functionality enabling controls, including pre-trading limits, over non-member client business may be limited by the extent to which such business is separately identified in their account structures, the following functionality is recommended to enable effective management of client risk.

(a) pre-defined authorizations

o trading capacity: functionality to limit trading by NCMs and non-member clients to specified instruments only (as reflected in their agreements with clearing firms).

o give-in/up capacity: functionality to limit give-ins/ups from NCMs and non-member clients specified by clearing firms.

(b) limits

o functionality to limit maximum order size by NCM and non-member client.o functionality to limit net long/net short positions by NCM and non-member client

on a daily basis.o functionality to limit net long/net short positions in relation to open interest (at

close on T-1) on a daily basis.o functionality to establish pre-trading limits (vs. termination of trading on a post-

trade basis).

(c) monitoring capability

o functionality to enable tracking of all working/open orders and give-ins/ups.o functionality to enable tracking of all executed orders and give-ins/ups.o capability to enable real-time or near to real-time tracking.

(d) intervention capability

o functionality to enable cancellation of all working/open orders by NCM and non-member clients.

o functionality to limit new order entry to position-reducing orders only.


(ii) Market data (discussion of data on large and concentrated positions is covered in section D)

Risk assessment

Data on open interest in exchange contracts, traded volume in those contracts, and price data including bid-ask spreads, play an important role in the risk management and evaluation undertaken by clearing firms in their client risk management. Open interest data are used to assess the relative size of the positions of larger clients in individual and related contracts, and in conjunction with volume and price data to form a view on market depth and of how quickly, in extremis, the positions of a client could be closed out or hedged prior to close-out.

Most futures markets make comprehensive open interest, trading and price data publicly available and regard the data as key information and a distinguishing characteristic of transparent, central marketplaces. Insofar as the standards recommended imply change, the change would further develop the current transparency that sets the markets apart from most others.

Clearing firms believe that exchange markets that use their facilities to offer registration and clearing services to “OTC” trades that are based on the same underlying instruments as their conventional exchange-traded contracts should publish equivalent open-interest and volume data covering the “OTC” business.

One particular concern in this area is that the information for inter-professional derivatives markets in energy products, although they are large and important markets under common ownership with “traditional” futures exchanges and inter-linked with those exchanges in price formation, is not fully available. This is regarded as detrimental to the effectiveness of client risk management in those markets, which are also centrally cleared, and in the related futures markets. It is felt, additionally, that in the case of those markets and their associated futures exchanges, the regulators involved should consider the case for their receiving sufficiently detailed information to enable the compilation and dissemination of consolidated open interest data.


Recommended standards to ensure adequate controls

Whilst it is recognized that exchanges’ ability to publish aggregated information relating to non-member client business may be limited by the extent to which they hold such information, and taking account of the additional work on open interest methodology planned by FIA/IFM [see section B (f)], the following standards are recommended to improve clearing firms’ ability to manage their client risk.

(a) publication of data

o exchanges should make available on a daily basis, preferably in electronic format such as an open messaging protocol or file transfer program but in any event in a format discussed with their membership, comprehensive data of open interest in exchange contracts and related registered OTC contracts, traded volumes in the same contracts, and bid-ask data at contract level (average and range).

o exchanges should make historical series of the open interest, volume and bid-ask data available for risk analysis.

(b) standardization of open interest data

o work should be undertaken to produce a model reporting format for open interest to be adopted by all exchanges (see the further work proposed under point (f) in section B).

(c) consideration of the case for consolidated open interest data

o in the case of the inter-professional OTC energy derivatives markets and their related futures exchanges, the case for the compilation of consolidated open interest data on common definitions should be considered by the CFTC and FSA. When the issues raised in connection with energy derivatives have been addressed, the need for similar data for directly competing commodity derivatives contracts and markets should also be considered.


D. Standards for clearing houses (and exchanges in some instances)

Risk assessment

Clearing house or exchange initial and variation margining is a central pillar of risk management in the futures markets, as the margining of clients by clearing firms takes its lead from the “central” margining processes. The recognition of the effectiveness of margining in containing risk is reflected in various sets of regulatory capital rules covering counterparty and market risk requirements, and overall capital standards in the case of US FCMs iv.

The link between clearing house or exchange margining and clearing firms’ margining of clients is close but not a precise reference point. Some clearing firms regularly set client margins above those set centrally for clearing members by the exchanges, while many offer margin offsets, for risk-reducing positions originating in different markets and cleared through different clearing houses, which are not matched by offsets arranged between the clearing houses.

Notwithstanding the fact that the link is not precise, in the evaluation process several broker-clearers questioned the adequacy of clearing house and exchange margining in relation to large, concentrated positions in general, and to those in commodity contracts and in options in particular. Their concerns focused above all on their exposure to client risk if they accept the central margin rates as adequate, but the question of the integrity of clearing house arrangements—their ability to absorb the costs of a large member default and to contain systemic risk—was also raised in connection with the question of how long it would take a clearing house to close out a large position in the event of clearing member default.

The work included a survey of margining techniques and approaches to large and concentrated exposures at the clearing house level. The conclusions drawn are reflected in the proposed standards for clearing houses and clearing firms. There seems also in this connection to be the need for a better understanding on the part of clearing firms of differences between themselves and clearing houses in terms of margining and risk management generally. This aspect is covered in the appendix to the report.


Recommended standards to ensure adequate controls

(i) margin parameters

o Margin parameters for individual contracts should take into account the existence of large positions that could have a significant influence on prices. Reflection of this potential risk should form part of an overall approach that distinguishes between contracts on the basis of their relative liquidity and open interest, and does not treat all contracts on the same basis irrespective of their risk characteristics. It is understood that composite qualitative adjustments, rather than separate mechanical adjustments, are the method of reflecting the inter-related risk factors favoured by most clearing houses, and that the most common approach to large positions is to increase margin requirements for the member or members carrying such positions rather than to increase parameters for all clearing participants and accordingly the market as a whole. Although mechanical adjustments to take account of relative liquidity or contracts in which open interest is narrowly held are not favoured, the most obvious method of systematically adjusting margin parameters to take account of such variables is to use an adjusted statistical treatment that is more conservative than the core approach to “standard” contracts: based for example on price movements over a longer time period and/or employing a higher confidence level.

o Clearing houses using or developing margining set at an aggregate portfolio level using a portfolio VaR approach, rather than a scenario approach that aggregates margin for individual contract families, should explain how those approaches take account of differential risk characteristics at the contract level.

(ii) transparent description of methods and assumptions

o Clearing houses should review the descriptions of initial margin method currently made available and should make explicit if it is not already: their standard statistical confidence level for margin parameters, with commentary on the more qualitative approach to upward and downward adjustments from the statistically derived “base” calculations; the price series reference period to which the confidence level relates (3 months, 6 months or longer); the holding period in days (one day or two days or more) to which it relates; the relationship in terms of risk coverage between their initial margin requirements and other funds they maintain that are available to cover default losses that exceed initial margin; their general assumptions about “time to liquidation” of clearing member portfolios in the event of default; the extent to which their method distinguishes between contracts on the basis of differential risk characteristics; and the frequency of their reviews of the appropriateness of margin parameters and the decision-making process that governs whether parameters are maintained, increased or decreased. In cases where clearing houses employ different approaches in respect of different contracts or types of contracts they should indicate the core differences.


o Clearing houses should consolidate descriptions of initial margin method and assumptions if they are currently provided in a number of documents and service descriptions, none of which comprehensively covers the areas specified in the above.

(iii) further information for clearing members to assist their risk management of exposures to clients

o Clearing houses’ ability to hold or communicate client-related information is limited by law in certain jurisdictions, preventing their meeting the first standard recommended below. In cases where clearing houses and/or exchanges have information on client positions and the market rules permit clients to hold positions in the same contract with more than one member, clearing houses or exchanges should inform the clearing members in question when the aggregate position has the potential, in the opinion of the clearing house or exchange, to influence price formation in the contract in question. In developing their policies in this area, clearing houses and exchanges should decide whether to use automatic, quantitative triggers for such information dissemination, a more qualitative approach, or a combination of the two.

o In cases where regulators rather than clearing houses hold information on client positions referred to in the paragraph above, clearing houses and exchanges should work with their regulators to put in place similar information dissemination in the interests of market security and integrity.

o Clearing houses should consider, in order to assist the risk management of their broker clearing members, either the dissemination alongside their standard parameters of parameters based on five- and ten-day price movements, without qualitative adjustment, in respect of price moves over the historic reference period that most informs their standard parameter setting, or the provision of information enabling broker-clearers to calculate the additional parameters themselves. These additional parameters could be produced by clearing houses at the same time as their core evaluations and assist in their stress testing.


(iv) risk dialogue between clearing houses

Clearing houses’ ability to communicate with other clearing houses may be constrained by the law in certain jurisdictions, although the recommendations below do not suggest the exchange of detailed client-related information.

o In cases where identical or near identical contracts are cleared by two or more clearing houses there is the potential for concentrated, price-influencing positions to be opened across the separate markets and for the overall size and possible impact to be invisible to any one of the clearing houses individually. In such circumstances, risk managers at the clearing houses, regardless of commercial rivalries between the cleared markets, should, in the interests of market integrity, develop a dialogue that enables them to supplement their own information on large positions and to put them in a better position to protect users of the markets.

o For the avoidance of doubt, this recommendation does not seek to promote such dialogue in the case of similar product types, for example, equity index products based on the Dow Jones and the Nikkei, nor in respect of smaller contracts such as equity futures and equity options, although as relationships develop the extension of dialogues could well be appropriate. Equally, it does not suggest that the regular exchange of detailed information is necessary; it advocates the establishment of communication channels that would enable confirmation or otherwise of whether large positions in one market are paralleled by large positions in another.


E. Standards for clearing firms

(i) Margining of clients

o In establishing margin levels for their clients and managing their client risk, clearing firms should take full account of: the fact that they do not benefit from the additional, above initial margin, risk protections of clearing houses; that in handling default by one of their clients they do not have the option of transferring its business as clearing houses do in the case of the client positions of a defaulting clearer; that the modus operandi of clearing houses is to initiate default action with dispatch, particularly in response to non-payment, in order that their assumptions about close-out periods are not invalidated; and that in their default handling most clearing houses benefit from special protection under national laws, and in some cases from status that is recognized in several countries. For these reasons, standard clearing house or exchange margins (“exchange minimum”) are to be viewed as a minimum in terms of adequacy for covering client risk. Particular attention should be paid to whether it would be appropriate to establish higher requirements in respect of individual (and connected) clients:

• incaseswheretheclientsholdlargepositionsrelativetoopeninterestandaverage traded volume, concentrated in one or two contracts, or in contracts whose underlying is the same asset class and may in some cases be traded on different exchange markets;

• andincaseswhereroutineprocedurewouldbetoconsultwiththeclientinrelation to non or partial payment or perceived future difficulties in a way that would clearly invalidate the close-out assumptions underlying clearing house margin parameters.

In making such adjustments, clearing firms should pay attention to differing practices amongst clearing houses. The additional margin parameters from clearing houses will assist their efforts.

o Clearing firms should monitor their client exposures on an intra-day basis. On the basis of knowledge of intra-day and close-of-day exposures, and of their ability to call intra-day for additional cash or collateral from clients, they should be prepared to increase margin requirements or seek additional collateral whenever appropriate on risk grounds.


(ii) Contractual agreements and financing of client margin

It follows from the critical need to assess the adequacy of margin collected from clients that clearing firms should contractually commit themselves to collecting no more than exchange minimum only after rigorous assessment of the quality of their counterparty and of the inherent market risks of the positions cleared. This risk evaluation is even more critical if financing facilities will be offered.

(iii) Information about client exposures

o As an integral part of their client risk management, clearing firms should require clients to tell them when they are clearing individual contracts through more than one firm and to name the other firm or firms. When clearing firms have concerns about the size of positions in individual contracts opened for any client, and that client is known also to hold positions through another firm, they should ask the client for information on its consolidated positions. In cases where the clearing house or exchange in question does not hold information about individual client exposures and the firm will accordingly not be notified if the consolidated position exceeds certain thresholds, it should consider direct liaison with other relevant firms, subject to its client confidentiality undertakings and the extent of its risk concerns.


Appendix: initial margining—clearing house and clearing firm perspectives

Although initial margin is central to clearing house risk management, clearing houses have a number of complementary and supplementary risk protections. These give access to additional resources intra-day, or supplement margin on a permanent basis (contributions to clearing and default funds and security deposits). In addition, clearing houses will, if they are concerned about the ability of a clearing member to support positions registered in its name, including positions that may be very concentrated in one contract or group of price-interrelated contracts, collect margin additional to standard requirements (“super-margin”). Such additional margin requirements are specific to individual members and are not reflected in an overall increase in margin parameters.

At the same time, the member default arrangements of many clearing houses are given special legal protection under bankruptcy and insolvency laws. In most cases, the events or actions or inactions that may trigger declaration of member default by a clearing house are listed formally in default rules, and clearing houses have a track record of acting decisively and quickly in order to protect the cleared markets if a clearing member breaches their default rules. Clearing member contributors to clearing houses’ mutualized risk funds have an interest in decisive and quick action: their funds are at risk.

Clearing firms collecting what is typically described as “exchange minimum margin” from clients—that is, the same margin requirement that would be applied by the clearing house if the contracts were directly registered with it (except that it will not reflect any supplementary margin in relation to concentrated positions as referred to in the first paragraph above)—are unlikely to have the same access to payment of variation margin or additional cash margin intra-day as clearing houses; and unless they collect margin additional to “exchange minimum margin” they will not have any supplementary cover approaching the equivalent to the contributions to clearing and default funds and security deposits held by clearing houses. Nor do clearing firms have special insolvency law protection, and for that and other reasons may either not wish or not be able to act as quickly as clearing houses do in relation to client difficulties.

Clearing firms should be aware that clearing houses collect additional margin or take other measures if they are concerned about concentrated positions held by clearing members.

Acting in the opposite direction, other factors may work to bolster the adequacy of “exchange minimum margin” collected from clients by clearing firms. For example, the clients may have business on more than one exchange in which there are risk-offsetting positions that are not reflected in the margining of either market. Or clearing firms may also handle risk-offsetting cash positions or uncleared OTC derivative positions for clients. Notwithstanding these possibilities, an appreciation of the differences between clearing house and clearing firm risk protections should give clearing firms a sharper focus on their own risk management priorities.


Footnoted references

i Futures is used here to refer to futures and options on futures (all underlyings) and to options on securities and equity indices outside the US.

ii The project sponsors are FOA and FIA, CME Group, Eurex Clearing, ICE Clear U.S., LCH.Clearnet, and New York Mercantile Exchange.

iii FIA, Profile of Exchange and FCM Risk Management Practices for Direct Access Customers, December 2007.

iv All the Basel capital rules recognize the risk-reducing nature of initial margining and daily variation margining, as do the equivalent rules agreed by EU countries in the form of various directives. The adjusted net capital rules applicable to futures brokers in the US take as their basis the principle that regulatory capital should cover at least minimum proportions of total global margin collected and paid by brokers.

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