The Bank of England has published a speech given by David Bailey, Director of Financial Markets Infrastructure Supervision. The speech is entitled Default management by central counterparties: the importance of preparation.

In his speech Mr Bailey discusses the way in which central counterparties (CCPs) test their default management preparations and procedures via default management ‘fire drills’.

Mr Bailey notes that CCPs are increasingly connected with many key market participants and that it is more likely than not that a material clearing member default will impact multiple CCPs at the same time. Therefore regulators and CCPs must evolve some fire drills towards multiple CCP scenarios in order to provide a realistic simulation of a material clearing member default.

Mr Bailey then describes a 2016 fire drill which involved the default of a common hypothetical clearing member clearing interest rate swaps and futures which was integrated into two CCPs’ annual fire drills which were held in parallel. Mr Bailey discusses some of the findings from this exercise focusing in particular on the:

  • extent to which clearing members’ internal procedures support their ability to second traders to multiple CCPs, in parallel, in order to participate in default management groups; and
  • operational capacity of clearing members to process auction files from two CCPs.

Mr Bailey also mentions that a number of prerequisites were identified for running more effective fire drills across multiple CCPs. These include:

  • more tightly defining the timing of the CCPs’ hedging activity and auctions, to ensure that the exercise robustly tests clearing members’ capacity to participate;
  • ensuring defaulted portfolios are material in size with correlated risks above clearing members’ business as usual risk model assumptions, so that the exercise identifies and really tests the clearing member’s risk management capacity; and
  • enabling regulators to complete an ex-post review of clearing member auction bids, particularly to assess the impact of capital or liquidity costs on bids.

Mr Bailey ends his speech by briefly describing the next multiple CCP fire drill which will take place in 2017. The scenario and objectives of this drill are still being defined but will include testing hedging and auctioning procedures at the CCPs and at members in stressed market conditions. Consideration is also being given to testing the capacity of client porting arrangements.

View Default management by central counterparties: the importance of preparation, 17 November 2016