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Marcus Addison on default management auctions

Release date: 06 Jun 2019 | Eurex Clearing, Eurex Exchange, Eurex Group

Marcus Addison on default management auctions

“You must be prepared. Practicing regularly helps.”

A default management process is initiated if a clearing member defaults. As part of this default management process, clearing houses can conduct auctions to manage the risks associated with a default, such as the recent Nasdaq default. What makes a successful auction and how is it conducted? Marcus Addison, Head of Default Management at Eurex Clearing, explains the important details.

Marcus Addison, Head of Default Management at Eurex ClearingZoom

Marcus Addison, Head of Default Management at Eurex Clearing

What exactly happened during the Nasdaq default?

Of course, we don‘t know all the details. But Nasdaq has published quite a lot and what we know for sure is that the trader Einar Aas held a very large spread position – Nordic Energy versus German Energy. This is not an unusual position.

The setup is unusual, which allowed Mr. Aas to “clear” himself, i.e. there was no other entity or clearing bank upstream and Mr. Aas was liable to Nasdaq as a private individual.

We had a very dry summer in Germany last year, but in Norway there was quite a lot of rain. There is a lot of hydro energy there, water-based power generation, and overcapacities were produced. As a result, the price of the corresponding futures fell. At the same time, there was a decision in Europe to issue fewer emission certificates, which means that the price of energy rose.

As a result, the spread between the two contracts moved strongly...

... and the participant lost a lot of money. He was not able to serve the margin call calculated by the Nasdaq. As a result, his clearing license was terminated, a standard process if a margin requirement is not met. The CCP must then liquidate the position. An attempt was made to hedge the market risk, but this did not work, and Nasdaq then switched to auction mode.

How did the auction go and what questions did it raise?

The auction went well in the second attempt with four auction participants. The total losses, i.e. auction prices plus accumulated variation margin, exceeded the existing margin and around two thirds of the clearing fund were used up. This result is extremely critical and started discussions on the topic.

Nasdaq has about 160 clearing members and, of course, the question arises why only four of them appeared at the auction. At Eurex Clearing we wouldn‘t even call something with five participants an auction. That is an “Independent Sale”. Especially in the case of large positions, you should invite as many participants as possible to the auction. I‘m thinking of ten to 20. There should also be an obligation for auction participants and the CCP must incorporate appropriate incentive mechanisms. The latter is quite simple via the clearing fund. This is the money of the participants and those who refuse to participate in an auction should be at the front of the queue to cover any losses incurred. This is called “juniorisation” and it works quite well. Voluntarily or a lack of incentive, especially at critical auctions, can be a problem. Anyone who can participate should do so, there can be no excuses.

What makes an auction a success?

That is a difficult question. Of course, an auction is successful if the items are sold at the end of the day. But there are additional dimensions, especially price and time. Naturally, you want to liquidate all positions as quickly as possible, but acceptable prices must also be achieved. A really successful auction achieves reasonable prices “in time”, “in scope”.

What role does the portfolio size of the defaulting member play?

Of course, this plays a role. If I have a very large position, auctions are very complicated. With a very small position an auction may not be necessary at all, then I can place en bloc in the market. The bigger, the more difficult it becomes.

Size is to be seen from a risk perspective. The main parameter is the margin requirement for the portfolio to be auctioned. If I have an auction with 10,000 products, but the margin requirement for the portfolio is only 1 million euros, then the risk is relatively small or “flat”. If, on the other hand, you have a very small portfolio with only two futures, as in the Nasdaq case, but with a very high risk and a correspondingly high margin requirement, you have a problem. Because whoever buys this position must then immediately set this margin himself.

Are there other parameters that are important here?

Yes, the technical size of a portfolio. How many products are included? How many lines of information do I have? For example, if you have a book with 20,000 swaps in the OTC area, then you need IT systems that can process this amount.

Does the willingness of auction participants to serve large orders decline in volatile market situations?

Of course this decreases and the bid/ask spread you must expect becomes even wider. As a participant, I may be willing to take on a large position even in a crisis, but then I expect a correspondingly large premium. At some point this can go so far that a portfolio is too large, and you can‘t find anyone who wants to take it. Especially in an unfavorable market structure, for example when 90 percent of the risk is distributed among two participants and the rest is divided among 100 other, smaller participants. If one of the two big players fails and the other doesn‘t want to take the position, what do you do?

There is an obligation to participate in an auction, but, of course, only in regards to a size that can be represented for the participant. We would then have to hedge this portfolio in order to return it to an acceptable size in terms of risk. Or we would have to break down the portfolio into small enough parts so that smaller participants could then bid again.

What possibilities are there to avoid unnecessary risk premiums?

There are actually only a few options. The best way to reduce portfolio risk is through hedging. Afterwards, the probability of achieving acceptable prices in an auction is quite good. The risk premium should then be moderate.

How exactly does Eurex Clearing proceed in such a case?

We are very stringent. In the first step, we analyze what the exposure is, exactly which positions we have and which steps we must take.

Above all, you have to be prepared technically, operationally and in terms of personnel. You need traders to do that, without them you can‘t do it. You need the appropriate tools and IT systems so that you can process complex positions with 10,000 lines of information.

But above all, everything has to happen very quickly, because we only have a few days in such a default management process. In this short time, however, we may have to move positions worth tens of billions. The auction process should involve as many smaller participants as possible. For example, we also take in customers because they can offer very competitive prices. And the most important thing: all participants in an auction must know and master the process. You must practice this regularly. We do this at least once a year with a large round and with the large market participants on a monthly basis. And we have had good experiences with this, because we have never touched the clearing fund! We have always managed to cope with the margin of the defaulting participant.