Photographer: Simon Dawson/Bloomberg

Clearing Firms Simulate Lehman-Like Default During Brexit Chaos

  • Regulators asked to test clearinghouses during market shock
  • Each clearing firm successfully completed hedging and auctions

The first coordinated global test showed clearinghouses, the firewalls protecting the financial system from calamity, are strong enough to survive a major bank going bust.

Regulators wanted to know what would’ve happened if there’d been a Lehman Brothers Holdings Inc.-style collapse during a market shock like that of the Brexit vote last year. So they asked three major clearinghouses -- LCH, CME Clearing and Eurex Clearing -- to run a simulation.

The test involved each clearinghouse pretending it had to auction a portfolio of debt and equity derivatives backed by billions of dollars of collateral, or initial margin, in cash and bonds. The auctions were simulated as if taking place at the end of June 2016, during the fallout from Britain’s surprise Leave vote.

Several hundred traders took part in the April drill, with more than 50 banks or trading firms involved in three auctions held by Eurex. The U.S. Commodity Futures Trading Commission said each clearinghouse successfully completed its hedging and auctions.

“It is important that default drills be as realistic as possible, and large member firms usually clear at multiple central counterparties in more than one jurisdiction,” said CFTC spokeswoman Erica Elliott Richardson. “This is why the drills are held in the U.S. and Europe at the same time. The analysis by the authorities is not yet complete, but the results are positive.”

Eurex, a unit of Deutsche Boerse AG, said it contained the fallout from the collapse, successfully stopping any of its other members from losing collateral.

“We had a pretty bad first day: we lost half the initial margin on day one,” said Marcus Addison, Eurex Clearing’s head of default management. “We started hedging immediately and that means we locked in the move, but at least we stopped the bleeding immediately.”

At Eurex, the initial margin at stake in April’s fire drill was 2 billion euros ($2.3 billion), about 2 1/2 times the size of Lehman Brothers’ collateral at Eurex Clearing when it went bust, Addison said. LCH, the world’s largest clearinghouse, has never disclosed how much initial margin Lehman held with it when the bank collapsed.

The ability of clearinghouses and their trading members to handle a default has risen up the agenda of regulators in the U.S. and Europe in the years after the financial crisis. LCH’s successful auction of Lehman Brothers’ $9 trillion interest-rate swap portfolio in 2008 was one of the key events during the crisis. After the crisis, regulators around the world pushed for more derivatives trading to go through clearinghouses to reduce the risk of a default spreading across the system.

To read more about how Brexit puts financial clearing work up for grabs, click here.

London Stock Exchange Group Plc., which operates LCH, confirmed that the drill was completed successfully and that LCH “didn’t breach the first layer of the default waterfall,” a spokeswoman said. A spokeswoman for CME Group Inc., which runs CME Clearing, confirmed the company’s participation in the drill and declined to comment further.

A spokesman for the European Securities and Markets Authority declined to comment.

LCH, CME and Eurex are three of the world’s four biggest clearinghouses. Intercontinental Exchange Inc.’s clearinghouse -- the third largest -- was not included in the exercise. An ICE spokesman declined to comment.

— With assistance by Silla Brush

    Before it's here, it's on the Bloomberg Terminal.
    LEARN MORE