The Central Counterparty, BME CLEARING, puts itself before both counterparties in a financial transaction. When interposed, several risks affect the CCP. The main one would be the counterparty risk, also called credit risk. However, there are other risks that affect BME CLEARING, amonge them concentration risk and the wrong way risk. In the side menu, you would be able to find further details about these three risks.
Types of Risks
Credit risk (also called counterparty risk) can be defined as the loss assumed by an economic agent in a financial transaction if its counterparty fails to fulfil its obligations.
As an example, the loss of a counterparty in a loan that is not paid or in a derivatives contract when the other counterparty defaults.
Therefore, is the risk on a value of an asset caused when the counterparty of the contract defaults.
When trading bilaterally (OTC), there must be taken into account critical aspects such as the rating of the counterparty or de credit spread in order to choose the counterparty of the trade and hedge the risk, for example, via Credit Default Swaps (CDS) or any other instrument that enables to cover the counterparty risk.
Trading bilaterally (OTC) has counterparty or credit risk.
With a CCP, the counterparty or credit risk is transferred entirely to the CCP and is almost entirely mitigated in the case of the counterparties.
BME CLEARING, as Central Counterparty, novates the trades, putting itself before both counterparties, performing registration, central-counterparty, clearing and settlement functions.
The main purpose of BME CLEARING is to eliminate the counterparty risk and to ensure the transactions are completed successfully.
For that, BME CLEARING measures risk exposure to its counterparties in real time using its risk management system, considering the current collateral posted.
Besides, BME CLEARING establish solvency requirements for Members based on their category in the CCP, BME CLEARING require the posting of Margins, applies Variation Margin in Futures and xRolling contracts, sets Risk, Margin Call and Concentration Limits, performs stress tests for Margin calculation and follows the Default Waterfall in case of Default.
When a portfolio contains a position whose exposure exceeds a specified threshold, the portfolio is considered concentrated, meaning it carries a higher concentration risk associated with that position.
The same principle applies to securities provided as collateral to cover margin requirements. If the collateral is concentrated in a limited number of securities, concentration risk will also arise in the collateral posted.
The purpose of BME CLEARING is to eliminate counterparty risk and ensure the successful settlement of transactions by acting as the central counterparty to all trades cleared through its systems.
In the event of a clearing member default, BME CLEARING will first seek to close out the defaulting party’s positions and transfer its clients’ positions to another Member. It may also liquidate, in whole or in part, the securities posted as collateral to satisfy margin obligations.
Where a position or collateral is highly concentrated, this process becomes more complex. Large positions are inherently more difficult to close out efficiently.
To mitigate concentration risk arising from collateral posted as margin, Concentration Limits are established. These limits are described in detail under the Eligible Assets section of Collateral Management.
Where a Position Account records a position that may be classified as a Large Position, BME CLEARING will apply an increase to the Position Margin requirement by widening the applicable margin interval by a specified percentage, as set out in the Additional Margins for Large Positions Circular for each Clearing Segment.
The assessment of whether a position qualifies as a Large Position is based on the Average Daily Volume (ADV) methodology, as detailed in the General Circular Average Daily Volume.
As a central counterparty, BME CLEARING has exposure to both counterparties in a transaction and also has credit risk exposure to the issuers of the Margin Collateral accepted in the form of securities.
Both exposures are correlated with the credit quality of the counterparty and the issuer of the security.
If this credit quality suffers a downgrade, the risk of default increase and also the credit exposure, both against BME CLEARING.
This is what is called wrong way risk.
BME CLEARING has measures to avoid or at least mitigate the correlated collateral and the wrong way risk.
For example in the Cash Equities Segment, when stress test is done in securities within the Banking sector, in those securities where the issuer is also a Clearing Member in BME CLEARING, in one of the scenarios of the stress test a -50% downward price movement is applied to that security, applying to the rest of securities the fluctuations indicated in the Cash Equities Segment Circular “Stress Test Calculation Parameters”.
One example regarding mitigation of wrong way risk in the collateral posted in the form of securities are the Haircut Adjustment for the different Government Debts eligible as collateral but not included in the Reference Basket, based on the differential in respect of the latter. If the return on any Government Debt (eligible as collateral but not included in the Reference Basket) in the secondary market, as based on information obtained from the Reuters or Bloomberg agencies is higher than the return of the Reference Basket over two consecutive days, and according to the levels set out in the “Valuation of Securities posted as Margins” Circular, the haircuts of that particular Government Debt will be increased for bond buyer positions, resulting in an increase of the Initial Margin required.