Central counterparties (CCPs) like OCC have performed extraordinarily well during many stressful periods, including the financial crisis of 2008. This is due to the many clearinghouse innovations that have been put in place, including mark-to-market settlements, initial margin models, and default management processes. As a reminder, CCPs do not take on any market risk. Instead, we manage risk. We add a critical risk management function to the financial system and, when one of our clearing members is in default, we act, as we did in the wake of Lehman, MF Global and others.
CCPs have become more critical to the financial industry, as reflected in our designation as systemically important financial market utilities. We have endeavored to make our processes even more transparent to the public, with the adherence to the Principles for Financial Market Infrastructures (PFMIs) and the distribution of both qualitative and quantitative information, so that market users can better understand the overall risk management of CCPs and participate in risk committees or other advisory forums.
At OCC, we look to have a broad clearing membership that includes all qualified participants, as we want to have a large and diversified set of clearing members. Initially, we consider whether potential clearing members are regulated entities. In the U.S., this means that they are either a registered broker-dealer or a futures commission merchant (FCM), and that they are a corporate entity.
Most importantly, each CCP continually monitors the credit risk of each of its clearing members that bring exposures to the clearing house by reviewing financial statements and market metrics. At OCC, we take this a step further and perform a risk review of each of our members, both at initial admission to membership and periodically thereafter, to ensure that they meet acceptable risk management standards.
CCPs' initial margin models are distinct from one another to reflect differences in the products and their inherent risks. This distinction prevents model risk that is created when using a single approach without tailoring it to specific circumstances. Much of the work CCPs do with regard to initial margin requirements is appropriately calibrating and reviewing initial margin models as conditions and products evolve. This process is one of the most critically important for CCPs. In this regard, OCC developed a 10,000 scenario Monte-Carlo initial margin calculation methodology called STANS. At OCC, the STANS (System for Theoretical Analysis and Numerical Simulations) margin approach is based on expected shortfall at a 99.0 percent level, which means we include all observations, including the worst-case scenarios, and average those amounts from 99 to 100 percent. OCC also employs a two-day margin period of risk for its initial margin model, which like the expected shortfall approach, exceeds the regulatory standards for exchange-traded derivatives to cover a 99 percent confidence level and a one-day margin period of risk.
In determining appropriateness, CCPs cannot only look at one aspect of a margin model. Margin resources are the primary way CCPs mitigate credit risks, but margin models are not calibrated to cover 100 percent of the risks. Therefore, CCP's utilize robust back-testing to assess the adequacy of its margin calibrations. For example, in the case of OCC's third quarter 2018 PFMI disclosure, which reflects the prior one-year period, there were 36 breaches out of 56,266 total back-testing observations, which represents 99.9 percent coverage.
The margin period of risk (i.e.; the estimated time needed to close out a defaulting counterparty's accounts), is another critical determination in calibrating appropriate margins. There is a distinction today between exchange-traded derivative and over-the counter products (OTC) in the regulations of a minimum one-day versus a five-day margin period of risk, which we think is appropriate given the liquidity and complexity differences of the products. We also believe that margin period of risk should be tied to the default management process, which has shown that a longer timeframe is needed to close out OTC products.
While the U.S. regulatory minimum margin period of risk for exchange-traded derivatives is one day, OCC believes that given the default management experience, which would likely involve an auction process, two days is more reflective of the practical timeframe needed to close out a defaulting counterparty's accounts. OCC has therefore set the margin period of risk at the more conservative two days for its exchange--traded derivative products. In our view, it's not about the minimum regulatory requirement, but rather about what is right for risk management.
Another important aspect of initial margin is the calculation of margin offsets for correlated products. Many CCPs offer margin offsets for products that are both economically and intuitively linked. These correlations must also be persistent and strong, and margin offsets should not be allowed for products that are tangentially correlated or in different asset classes. OCC has taken risk management a step further in its margin model and runs de-correlation scenarios where there is an additional charge at a higher confidence level based on the greater of historical, zero, or perfect correlations of products to cover the risk of markets moving in a much different way than in the past.
Other considerations when reviewing margin models include daily calibrations, the length of lookback periods, liquidity add-ons, concentration add-ons, wrong-way risk, and intraday margining capabilities.
Many of the considerations CCPs consider in establishing initial margin also apply to stress testing, as CCPs size their clearing funds at the appropriate levels. These considerations include using a robust number of test scenarios, de-correlation scenarios, and long lookback periods. The regulatory minimum in the U.S. is "cover 1", which means the CCP can cover the exposure of its largest clearing firm. OCC also exceeds this regulatory standard, having implemented in September a "cover 2" standard, which means covering our largest two clearing firm exposures.
Generally, CCPs look to bring many similar products into clearing fund and default waterfall to allow them to be risk managed together. While a clearing member may not clear every product cleared by the CCP, we want to have broad participation in a CCP clearing fund rather than small siloed funds for single products. If there is no recourse to access to other financial resources for small siloed funds, a CCP default is more likely, which would obviously be much more damaging to the customer, clearing firms, and the entire financial system.
CCPs work closely with clearing member firms and other CCPs to design and test robust default management processes, especially with regard to the auction process that allows a CCP to return to a matched book. This coordination includes vigorous testing of the auction process that includes participation from both clearing members and clients. Of importance in the default management process - and any stressed market environment - is the ability of CCPs to retain flexibility to react to the facts and circumstances at the time, as each stress event typically looks very different from past events.
As a systemically important financial market utility, OCC remains committed to serving as the foundation for secure markets and to ensuring confidence in the financial markets and broader economy. We will continue to invest in solutions that enhance our resiliency and fortify our operational effectiveness to reduce systemic risk across the global financial markets.
To learn more about OCC's thought leadership on industry issues, visit OCC's Blog.
This blog is adapted from remarks delivered on December 4, 2018 by Mr. Michaels to the Commodity Futures Trading Commission's Market Risk Advisory Committee.