Following the G20 summit in Pittsburgh in September 2009, Central counterparties have become, by design, an increasingly central pillar of the global financial system. This was driven by the resilience shown by CCPs during the crisis and, in particular, their ability to continue clearing contracts as bilateral markets dried up as well as their ability to default-manage the numerous derivative portfolios held by Lehman across CCPs around the world. These portfolios were auctioned, liquidated or transferred within a short time after the default at a cost which did not exceed the collateral posted by Lehman. Perhaps the highest profile example is the unwinding of Lehman's interest rate swaps portfolio cleared at London Clearing House (&ldquo;SwapClear&rdquo;) (66,390 trades, $9 trillion notional), which was completed within a third of the margin held, ensuring that neither the CCP nor its members sustained any losses. <p class="dossier">Subsequently the Principles for Financial Market Infrastructures (&ldquo;PFMIs&rdquo;) were agreed upon by global standards setting bodies in 2012. These principles have been supplemented by additional guidance in the following years and have established the global foundation for CCP risk management standards. Across the world, these principles have been incorporated into statutory and/or regulatory regimes enhancing CCP safety and soundness. This has been particularly important in the light of CCPs&rsquo; increased systemic importance. <p class="intertitre1">The Einar Aas case However, 10 years after Lehman, a proprietary trader with a much smaller portfolio in a much smaller market caused a significantly greater problem. On 10 September 2018 Einar Aas, a self-clearing Norwegian trader, was unable to honour a margin call to Nasdaq Clearing AB in Sweden. Extremely specific events, namely Nordic weather forecasts and a change in German carbon emission policies, caused the spread between Nordic and German electricity prices to widen significantly, generating substantial losses in Ass&rsquo;s cleared portfolio. When Aas was unable to pay the margin call, he was put into default by the CCP. Following procedure, the CCP managed the default by selling the position. In the following days, a private auction was held for Aas's portfolio with four of Nasdaq's other members. The other non-defaulting members unaware of the auction until after it had been completed. The winning bid crystallised a loss of &euro;114 million in excess of Aas&rsquo;s collateral. After the &euro;7 million of capital (Skin-In-The-Game &ldquo;SITG&rdquo;) provided by Nasdaq in its Default Waterfall, the remaining &euro;107 million shortfall was taken from the Default Fund, made up of contributions from the non-defaulting members. Fortunately, the Default Fund was sufficient to cover the loss without the need to consider Recovery or Resolution of the CCP. <p class="intertitre1">Default at Nasdaq Clearing For a CCP to exhaust the collateral posted by a defaulter is highly unusual. Since 2000 there has only been one other occasion where this has happened, when a trading error caused HanMag Securities to default on its obligations to KRX. The PFMIs contain guidance on how CCPs should set their margin levels to prevent this from happening. Among other principles, the guidance directs CCPs to calculate initial margins using a sufficient time horizon to assess potential market moves, use conservative assumptions on market liquidity, and only allow prudent offsets between products. Nasdaq has publicly disclosed how it calculated his initial margins with Aas to pay 99.2 % of the biggest two-day market movements over the previous year, plus 25 % of the biggest two-day movement that year. However, the CCP also allowed a reduction of 50 % on the assumption that German and Nordic electricity prices would continue to move in parallel. Perhaps more tellingly, there was no requirement to pay any additional margin to cover the possible liquidation costs of exiting the positions even though those positions were very large in the context of Nordic power market - a market that had shrunk significantly in recent years. <p class="intertitre1">What remains to be done The BIS Quarterly Review published in December 2018 observed the following: <ul> <li>&ldquo;How then was Lehman's default handled without losses in hard times, while Aas's default forced a CCP to pass losses to members? Lehman's portfolio, while large and complex, was relatively balanced and part of an even larger market. Although it was in supposedly more complex over-the-counter (OTC) derivatives, CCPs had adequate strategies and collateral in place. This was in stark contrast to Aas's portfolio, which was undiversified and heavily concentrated in a smaller and less liquid market. These episodes underscore the importance of maintaining sufficient market liquidity for central clearing to support default management in stressed conditions, and of applying a reliable long-term perspective in order to set accurate margins (Cunliffe (2018)). So, although Lehman's portfolio was much larger, CCP default management teams could hedge and reduce risks, allowing orderly auctions to take place over a number of weeks following the default.&rdquo;;</li> <li>&ldquo;These two defaults happened 10 years apart, under very different circumstances. Yet the lesson is timeless: sound risk management and preparation make all the difference between a CCP that absorbs a shock, and one that propagates it.&rdquo;</li> </ul> The default at Nasdaq Clearing clearly illustrates that, while significant progress has been made since the default of Lehman, a significant amount of work remains to be done to complete the global financial markets infrastructure to the robust standard necessary. While the PFMIs have been welcomed and implemented across the globe, they are non-binding principles and allow for a wide range of implementation approaches to be enshrined in the rulebooks of each CCP. Furthermore, regulatory frameworks which seek to manage the potential or actual failure of a CCP &ndash; Recovery and Resolution &ndash; remain in their infancy. <p class="intertitre1">Improve default management In the interest of financial stability and robust markets, CCPs must be fundamentally resilient, such that the default of a Clearing Member can be handled within the margins and other deposits provided by that Member. While many CCPs have made changes to their rules and models to reflect the PFMIs, there are a number of areas where scope remains for improvement: <ul> <li>CCPs should be required to develop conservative, granular margin models that have a high degree of confidence that they will cover the losses incurred in liquidating a portfolio;</li> <li>Extreme market stress events are likely to affect multiple clearing members. To cover potential default risks effectively, a CCP should, therefore, size its DF to cover at a minimum, the uncollateralized credit losses that would arise if the CCP&rsquo;s largest two clearing member groups were to default;</li> <li>CCP contributions to the default waterfall should be increased to meaningful levels of &ldquo;skin in the game&rdquo; (&ldquo;SITG&rdquo;) so that the interests of the CCP and the interests of members are better aligned;</li> <li>A CCP should only clear products whose markets are determined to be liquid enough to reliably absorb the risk of its largest participants in times of stress;</li> <li>The viability of a CCP depends primarily on its ability to manage clearing member defaults. Accordingly, each CCP should have a robust, transparent and credible Default Management Process (&ldquo;DMP&rdquo;), with the involvement of Member trading and risk-management experts and which should be tested periodically, at a minimum of once a year.</li> </ul> <p class="intertitre1">Operational Risks CCPs are responsible for managing substantial amounts of collateral and can be vulnerable to cyber-threats and attacks which could lead to significant monetary loss. CCPs can also incur losses resulting from other operational failures. It is generally not appropriate for clearing members or end-users to bear these Non-Default Losses (&ldquo;NDLs&rdquo;) since those members are not responsible for the decisions that lead to them. Regulators should require CCPs to manage, monitor, and hold sufficient capital against Operational Risks, to ensure that NDLs do not disrupt the CCP&rsquo;s ability to perform its obligations. <p class="intertitre1">Governance, Disclosure and Transparency In addition to these specific areas, there are also opportunities to improve the Governance, Disclosure and Transparency of CCPs to enable the members, who provide the bulk of the financial resources, to better understand the risks to which they are exposed. For example, while CCPs often have representation from a subset of members on their Risk Committees, consultation with members and end-users should be separate from these Risk Committees. Through this separation, all market participants can freely represent the views of their firms and other similar market participants. In addition, CCPs should be required to obtain explicit approval from clearing members (who ultimately bear the risk) before making any rule or methodology changes or introducing novel or complex products that materially affect the risk profile of the CCP. <p class="intertitre1">Recovery and resolution Beyond making CCPs more resilient, there are also opportunities to put in place some provisions to help the market accommodate the Recovery or Resolution of a CCP. These notably include: <ul> <li>Over and above the pre-funded Default Fund Contributions (&ldquo;DFC&rdquo;) of clearing members, CCPs should specify pre-defined assessment rights capped at one time each clearing member&rsquo;s DFC contribution. This has the effect of clearing members covering the cost of a CCP&rsquo;s Default Risk model being incorrect by up to 50 %, after which a second tranche of pre-funded CCP own-capital should be utilised. Such a limit on assessment rights reflects a fair balance between the members supporting the CCP to a high level and the risk appropriately borne by the CCP Shareholders;</li> <li>Should a CCP rulebook seek to allow the use of variation margin gains haircutting (&ldquo;VMGH&rdquo;) and/ or partial tear-ups (&ldquo;PTUs&rdquo;) as additional recovery measures, this use should be limited and only used upon review and approval by resolution or systemic risk authorities;</li> <li>Compensation should be provided to clearing members and end-users for losses incurred over and above their DFC plus pre-defined cash-assessments.</li> </ul> Finally, to address the very worst case, CCPs should be required to develop clear and credible resolution plans. These plans should be subject to regulatory approval, and sufficient transparency should be provided to all clearing participants. Furthermore: <ul> <li>CCPs should be required to set aside ex-ante resources for recapitalization with appropriate regulatory oversight. This could include long term debt that could be bailed in;</li> <li>CCP rulebooks should be subject to regular review in conjunction with CCPs&rsquo; primary regulators and systemic risk regulators to ensure a common understanding of CCP risk and default management, governance, policies, and key procedures;</li> <li>CCPs should form cross-border crisis management groups involving the major jurisdictions to which the CCP provides services, to develop and test resolution playbooks;</li> <li>Tools such as Invoicing Back, where the original counterparty is allocated the risk of the defaulter, and Forced Allocation, where risk is arbitrarily allocated to participants, some of whom may not be equipped to manage it, should not be permitted. Likewise, losses should be allocated via a comprehensive VMGH process that covers all clearing participants, ensuring that all Initial Margin deposits made by non-defaulters remain out of scope regardless of how they are posted to the CCP.</li> </ul> <p class="intertitre1">Robust all-weather defences Together, these proposals would ensure that CCPs have robust all-weather defences. The increased use of clearing in the post-Lehman financial system has been highly beneficial in terms of both market efficiency and financial stability across the whole financial ecosystem, and to the supervisors and legislators charged with developing and overseeing that infrastructure. However, recent events have shown that work still remains to be done to secure the financial and procedural backstops that support CCPs in a way which ensures that all market participants, including the CCPs themselves, have incentives that are fully aligned.