Derivatives Clearing, Default Risk, and Insurance

• Author: Robert A. Jones,Christophe Pérignon
• Date: 01 June 2013
• Published date: 01 June 2013
• DOI: http://doi.org/10.1111/j.1539-6975.2012.01489.x

C

The Journal of Risk and Insurance, 2013, Vol. 80, No. 2, 373-400

DOI: 10.1111/j.1539-6975.2012.01489.x

DERIVATIVES CLEARING,DEFAULT RISK,AND INSURANCE

Robert A. Jones

Christophe P´

erignon

ABSTRACT

Using daily data on margins and variation margins for all clearing members

of the Chicago Mercantile Exchange, we analyze the clearing house exposure

to the risk of default by clearing members. We find that the major source

of default risk for a clearing member is proprietary trading rather than

trading by customers. Additionally,we show that extreme losses suffered by

important clearing firms tend to cluster,which raises systemic risk concerns.

Finally, we discuss how private insurance could be used to cover the loss

from defaults by clearing members.

INTRODUCTION

Financial derivatives contracts, such as futures, options, and swaps, are exposed to

the risk of counterparty default. On organized derivatives exchanges, the central

counterparty clearing house (hereafter CCP) greatly reduces this concern by being

the legal counterparty to every transaction undertaken by a clearing member (CM).1

As an intermediary, the CCP does not incur market risk. But it does bear risk of

default by their CMs. Indeed, payment default occurs if the daily loss on a CM’s total

position exceeds its margin and it does not pay the deficiency on time.2

Robert A. Jones is at Simon Fraser University, Vancouver, Canada. Christophe P´

erignon is at

HEC Paris, France, where he holds the Deloitte and Soci´

et´

eG

´

en´

erale Chair in Energy and

Finance. The authors can be contacted via e-mail: rjones@sfu.ca and perignon@hec.fr, respec-

tively.We are grateful to two anonymous referees, ViralAcharya, David Bates, Laurent Calvet,

Jorge Cruz Lopez, Francois Derrien, Thierry Foucault, Laurent Fr´

esard, Thomas Gilbert, Amit

Goyal, JeffHarris, Christophe Hurlin, Dusan Isakov, Michael King, Paul Kupiec, Jacques Olivier,

Olivier Scaillet, Daniel Smith, Matthew Spiegel, Ren´

e Stulz, David Thesmar, and Christophe

Villa, as well as participants at the 18th Annual Derivatives Securities and Risk Management

Conference (FDIC), 2008 Meeting of the French Finance Association, 2009 Meeting of the Mid-

west Finance Association, and seminar participants at the Bank for International Settlements,

CORE-UCL, HEC Paris, and University of Geneva for their comments.

1The clearing activity consists of confirming, matching, and settling all trades on an exchange.

On most derivatives exchanges, only a subset of market participants (i.e., the CMs) can directly

trade with the CCP whereas all non-CM participants have to route their trades through a

designated CM. See Bliss and Steigerwald (2006) and Bliss and Papathanassiou (2007) for a

comparison of central clearing with alternative structures.

2See Knott and Mills (2002) and Pirrong (2009) for a comprehensive review of the risks faced

by CCPs and Eisenberg and Noe (2001) for a theoretical model of default propagation within

a clearing system.

373

374 THE JOURNAL OF RISK AND INSURANCE

The recent turmoil in financial markets has focussed attention on the crucial role

played by clearing platforms. Indeed, the lack of systematic central counterparty

clearing for over-the-counter derivatives has been identified as one of the causes

of the financial crisis (Acharya, Engle, et al., 2009). In his testimony before the U.S.

Senate in July 2008, Stanford Professor Darrell Duffie stated: “A central clearing coun-

terparty for the over-the-counter derivatives market could be essentially as safe as

exchange-based clearing.” In the aftermath of the credit crunch, many representatives,

senators, and members of the Obama Administration have recommended that over-

the-counter derivatives should be centrally cleared (Wall Street Journal, 2008; U.S.

Department of Treasury, 2009; Duffie, Li, and Lubke, 2010). While Duffie and Zhu

(2011) demonstrate theoretically that using a CCP for a given class of derivatives can

significantly alter counterparty exposure, the performance of such a risk-centralizing

institution has never been the focus of empirical work. Our objective is to fill

this gap.

In this article, we analyze CM default risk using observations of daily gains and losses

for all CMs of the Chicago Mercantile Exchange. 3Characterizing the probability of a

default by a CM—as well as the magnitude of the associated loss—is of interest to a

variety of market participants. First is the CCP itself, since, in the event of CM default,

it must use its own resources to compensate the winning CMs; once those resources

are exhausted, it too may default. Next are the nondefaulting CMs, because losses are

mutualized through loss-sharing rules. Third, individual investors holding positions

through defaulting CMs are at risk, since, as made clear by Jordan and Morgan(1990),

they are not contractually protected by the CCP. Further, CM parent companies are

directly concerned, since they may provide financial guarantees necessary for the CM

to operate. Finally,as implicit and explicit insurers of the CCP against default, central

banks and insurance companies may find such analysis informative (Bernanke, 1990).

Although actual defaults by a CM have been infrequent, concern about default risk in

the clearing process has recently increased.4Indeed, recent years have witnessed an

extraordinary expansion of the derivatives markets, fueled in part by the rise of the

hedge fund industry.In parallel with this increase, the emergence of mega-exchanges

resulting from mergers (e.g., Chicago Mercantile Exchange with CBOT, EURONEXT

with LIFFE) has led to fewer and larger clearing facilities.5This increasing concentra-

tion of risk in CCPs has raised systemic risk concerns. As noted by Federal Reserve

Governor Kroszner (2007), CCPs now clear many new products that are quite illiquid

or complex. In response to this growing concern, a number of CCPs have purchased

3The CCP is a division of the exchange, that is, Chicago Mercantile Exchange Inc. Exchange

members that are not CMs must be customers of a CM and pay a fee to have their trades

cleared.

4CCPs experiencing a CM default include the U.S. Options Clearing Corporation in 1973, the

New York MercantileExchange Inc. in 1976, the Commodities Exchange Inc. in 1985, and the

U.S. Board of Trade Clearing Corporation in 1992. Several CCPs have actually defaulted in

France, Honk Kong, and Malaysia. See Hills et al. (1999) for details.

5Interestingly,mergers of clearing facilities sometimes predate mergers of exchanges, for example,

Chicago Mercantile Exchange & Chicago Board of Trade.