LCH.Clearnet’s new proposed stress-testing framework

LCH.Clearnet have published a proposed stress testing framework that will inform and assist the review process being undertaken by CPMI-IOSCO.

As the use of clearing houses has increased, clearing members have found that there is currently no way for market participants to compare the risk and default management procedures of CCPs on a consistent basis.

The first tentative steps to address this issue were taken on 11 March, 2015, when the Committee on Payments and Market Infrastructures (CPMI) and the International Organisation of Securities Commissions (IOSCO) announced a review of stress testing by clearing houses.

CCPs regularly stress test their default management processes; however, as yet there is no global standard for a stress testing framework.

LCH.Clearnet thinks that a standardised stress testing methodology will help improve transparency around CCP risk management. It will allow clearing members and regulators to compare different CCPs on a relative basis, to evaluate the strength and resiliency of clearing houses and to assess the extent to which a CCP’s pre-funded resources (default fund contributions and CCP skin in the game) would be consumed under a uniform set of stresses. In addition, it attempts to place CCPs on a level playing field regardless of confidence levels used to calculate margin, holding and methodology for sizing default funds, etc.

According to LCH.Clearnet, there are five basic elements required to construct the standardised CCP stress testing framework outlined in this paper:

ELEMENT 1 The segregation of assets appropriate to eliminate masking effects within portfolios.

ELEMENT 2 The construction of a standardised stress testing framework using: Historical scenarios
Hypothetical scenarios
De-correlation stresses within the asset class

ELEMENT 3 Combining the results of the stress testing exercises across the three types of standardised stress scenarios.

ELEMENT 4 Stress testing the cover 2 standard to calculate the maximum number of members that could default simultaneously in each scenario without recourse to the CCP’s pre-funded resources.

ELEMENT 5 Evaluating the risk of successfully auctioning defaulted clearing members’ portfolio of trades under each cover 2 scenario without exhausting the pre-funded default fund of the CCP.

The full whitepaper can be read here.