Standard stress tests could create more risk, CCPs warn

Standardised stress testing of clearing houses – while attractive in principle – may drive risk management standards to the lowest common denominator and make the financial system riskier, clearing houses warn.

"Standardised stress testing is desirable, but the issue is the detail as to how this is done," said David Weisbrod, chief executive of LCH.Clearnet's US business, who was speaking at a conference yesterday.

Crafting a standard stress test that can be applied across jurisdictions and multiple products on different central counterparties (CCPs) with varying risk management practices will be a challenge, he said.

"We agree with the goal and we want to incorporate all the necessary detail so that we don't reduce it to the lowest denominator and inadvertently create more risk than we're trying to address," said Weisbord.

Sunil Cutinho, president of CME Clearing, was also sceptical about regulatory efforts to develop a standardised stress test. "You cannot get too granular because the risk profiles of the CCPs are different and the products the CCPs clear are quite diverse, so attempting a single stress test that fits all CCPs will not be successful," he said.

Weisbrod and Cutinho were speaking during a panel discussion at the Futures Industry Association conference in Florida on March 12.

The Bank for International Settlements announced on March 11 that the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (Iosco) would undertake a review of stress testing by central counterparties (CCPs). Risk.net first reported in October 2014 that the CPMI and Iosco had formed a joint working group to study the issue.

CCPs currently use stress tests to set the minimum size of their default fund, which is part of the waterfall of financial resources to which all clearing members contribute and is consumed after initial margin payments. According to the Principles for financial market infrastructures (PFMI) published in April 2012 by the CPMI and Iosco, the stress tests must be based on "extreme but plausible" scenarios. However, the principles are short on details and do not specify how the tests should be designed or conducted.

"The systemic importance of CCPs is growing substantially, not least due to the drive for standardised OTC derivatives to be centrally cleared," the regulatory bodies wrote in the March 11 statement announcing their plans. "The CPMI and Iosco therefore believe that a review of CCP stress testing is timely in order to identify how the relevant PFMI standards are being implemented and whether additional guidance in this area is needed."

The first public consultation meeting between CPMI-Iosco and market participants to discuss the matter will be held on March 26, according to sources with knowledge of the matter. 

Clearing firms and end-users, including BlackRock and JP Morgan, have called for a standardised stress testing regime for CCPs.

Marnie Rosenberg, executive director of clearing house risk management at JP Morgan, said the firm was ready to engage with regulators on the issue. "The starting point of [JP Morgan's] resolution plan for CCPs was that they need to be subject to a standard, regulatory-driven and transparent stress test framework, and I commend CPMI-Iosco for taking that up," she said.

"I'm looking forward to being involved in the CPMI-Iosco effort. I think its goal is twofold: setting more stringent standards – there will be consultation on that later this year – but separately it does not take away from the CCPs sharing information with members, and potentially clients, on their unique set of stresses, so that participants can get more comfortable that the coverage model is as sufficient as suspected," Rosenberg added.

CME's Cutinho turned the tables on clearing firms that have called for more stringent stress testing of CCPs, arguing client clearers should also be subjected to stress tests.

"From a client's perspective, if coming through a clearing firm, it is important for clearing firms to also submit themselves to stress tests, because when a clearing member fails, there are implications for its client. In the US we have a specific capital requirement for clearing members of 8% of gross margin that they have to maintain, but there is no stress testing on them. So if we are going to stress test, let's go all the way and look not at just one aspect of the chain, but at the member firms as well as the CCPs," Cutinho said.