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Categorized | Capital Markets

Derivatives traders forced to provide $27bn collateral post-Brexit

Posted on November 17, 2016

Derivatives traders were forced to stump up tens of billions of dollars the day after Britain’s vote for Brexit to cover volatile price movements, testing the foundations of the market’s post-financial crisis architecture.

Five of the largest clearing houses in the world demanded $27bn in additional collateral across derivatives products on June 24, according to data from the Commodity Futures Trading Commission, the main US derivatives regulator. That was $22bn, or five times, greater than the previous 12-month average, the CFTC found. 

The disclosure came as the clearing houses passed their first stress test from the regulator.

Clearing houses, or CCPs, are seen as critical backstops in derivatives markets, standing in as buyer to each seller and seller to each buyer on contracts ranging from interest rate swaps to oil futures. They collect collateral, or “margin”, to cover potential losses should a party to a trade default.

The CFTC noted that liquidity issues, as well as operational risk and cyber risk, were not covered by the stress test. The test only assessed a CCP’s ability to withstand losses given its current resources, so even if the $27bn called for after the UK voted to leave the EU had not been paid, the CCPs would still have passed. 

But some investors aired concerns over demanding large sums of money during stressed periods, sapping liquidity from the market. 

“There is more to the issue than just passing this test,” said Michael O’Brien, head of global trading at Eaton Vance. “Liquidity issues and margin calls are also very important to the system as whole.”

The CFTC carried out the test on five of the largest derivatives clearing houses: CME Group’s US business, London-based LCH and three businesses in the US and UK run by Intercontinental Exchange.

Crucially, every CCP was able to cover losses arising from the default of its two largest members, an international standard for clearing houses, in each of the 11 unique stress scenarios. The scenarios were developed after reviewing price movements on days with extreme volatility, including June 24.

“These first tests show that clearing houses had ample resources to withstand extremely stressful market scenarios on the test date,” said Timothy Massad, chairman of the CFTC. reported that LCH was addressing concerns over its margin processes that were criticised due to instances where the CCP calls for additional margin on contracts that move against investors but does not immediately return cash on contracts that have favourable price moves, leaving CCP members to fund the difference in between. Some initial changes took effect shortly before the US presidential election.

“I think [Brexit] was the first time the corporate treasurer knew my name … Had it been an unknown event, had it been an event we did not see, then the rally for cash would have been certainly more stressful,” said Tom Gillis, a futures executive at Wells Fargo Securities, at the FIA Expo conference in Chicago last month.

Stock, bond and currency derivatives underwent another big swing last week, as Donald Trump secured a surprise presidential victory. Daily volume on CME Group exchanges topped 44.5m contracts, smashing the previous record by almost 5m. US dollar interest rate swap volumes also surged, according to data from ClarusFT. But clearing house members and investors said margin calls were more moderate than in the days after Brexit.