Lehman and the Derivative Exchanges

The unredacted Volume 5 of the Lehman examiner’s report released earlier this week provides details about how CME handled the Lehman default by auctioning the positions of Lehman to other large dealers. The table below summarizes the data given in the report.

Asset Class	Negative Option Value	Span Risk Margin	Total Collateral	Price paid by CME to buyer	Loss to Exchange	Percentage Loss to Exchange	Loss to Lehman
Energy Derivatives	372	261	633	707	74	12%	335
FX Derivatives	-4	12	8	2	-6	-72%	6
Interest Rate Derivatives	93	130	223	333	110	49%	240
Equity Derivatives	-5	737	732	445	-287	-39%	450
Agricultural Derivatives	-5	55	50	52	2	4%	57
Total auctioned by CME	451	1195	1646	1539	-107	-6%	1088
Natural Gas Derivatives sold by Lehman itself	482	129	611	622	11	2%	140
Grand Total	933	1324	2257	2161	-96	-4%	1228

The negative option value is as the close of business before the Lehman bankruptcy and the loss to Lehman is computed as the excess of the price paid by CME to the buyer over this negative option value. Futures positions are presumably assumed to have zero value after they have been marked to market. On the other hand, CME incurs a loss only if it pays a price in excess of the collateral provided by Lehman. For comparison purposes, the same computation is done for the positions sold by Lehman itself, though, in this case, the exchange does not make any profit or loss.

What I find puzzling here is that in the case of interest rate derivatives, CME had to pay the winning dealer a price of about 1.5 times the collateral available. Had it not been for excess collateral in other asset classes, the CME might have had to take a large loss. Was the CME seriously undermargined or was the volatility in the days after Lehman default so high or was this the result of a panic liquidation by the CME?

We do have an independent piece of information on this subject. LCH.Clearnet in London also had to liquidate Lehman’s swap positions amounting to $9 trillion of notional value. LCH has stated here and here that the Lehman “default was managed well within Lehman margin held and LCH.Clearnet will not be using the default fund in the management of the Lehman default.”

A number of questions arise in this context:

• Did LCH.Clearnet charge higher margins than CME? It is interesting in this context that only a few days ago, Risk Magazine quoted LCH as saying that one of its rivals (IDCH) charges too low a margin: “bordering on reckless.” But LCH did not make this claim about CME.
• During the week after Lehman’s default, was there a big difference in the price behaviour of the swaps cleared at LCH and the bond futures and eurodollar futures cleared at CME?
• Was Lehman arbitraging between swaps and eurodollar futures so that its positions in the two exchanges were in opposite directions? In this case, price movements might have produced a profit at LCH and a loss at CME.
• Were the proprietary positions of Lehman at CME more risky than its (customer?) positions at LCH which might have been more balanced?
• Did the “panic” liquidation by CME exacerbate the loss? LCH hedged the position over a period of about a week and then auctioned off a hedged book.
• Did dealers trade against the Lehman book after the CME disclosed the book to potential bidders a couple of days before the auction? Or did each dealer think that the others would trade against the book? This problem did not arise at LCH because only hedged books were auctioned and the unhedged book was not disclosed to others.

In the context of the ongoing debate about better counterparty risk management (including clearing) of OTC derivatives, I think the regulators should release much more detailed information about what happened. Unfortunately, in the aftermath of the crisis, it is only the courts that have been inclined to release information – regulators and governments like to regard all information as state secrets.