Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Revisiting CME and LCH handling of Lehman default

A year and a half ago, I had a blog post comparing how CME and LCH.Clearnet coped with the Lehman default. I raised a number of questions and concluded by saying that:

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.

While regulators have still not been too forthcoming, considerable new information has become public since then. Somehow I did not get around to revisiting this issue until I received a comment on my blog post a few days ago from Risk Dude saying:

LCH utilized excess margins from other products to auction the IRS book under margin. So it’s a bad comparison.

This comment appears to be quite correct. The best material that I have read on the subject is the book by Peter Norman entitled The Risk Controllers: Central Counterparty Clearing in Globalised Financial Markets, (Wiley, 2011). Chapter 2 of the book deals exclusively with the Lehman bankruptcy, and Norman quotes a personal conversation with the LCH.Clearnet Chief Executive, Liddell in which Liddell says:

We always thought that a common default fund would be the main benefit from being a multi-asset CCP. … In fact, the big and far more valuable discovery during Lehman was that the initial margin in each market was completely fungible. … There were inverse correlations with prices moving one way in some markets, another way in others. As we managed to liquidate some of the portfolios more quickly than others, it meant that the margin that was left after some had been liquidated was available to cover risk somewhere else. That was a massive, massive benefit. … it meant we had a much bigger cushion all the time. … We didn’t have the same sort of urgent need to get rid of everything straight away.

Norman also explains that over the same weekend that Lehman failed, the energy futures exchange, ICE, was to move all its positions from LCH.Clearnet to ICE Clear Europe. On Sunday evening around 7 pm, the FSA, LCH.Clearnet and ICE Clear agreed to defer this move. This meant that during the liquidation of Lehman position, the ICE positions (and more importantly, the associated margins) were also available to LCH.Clearnet and this was a big benefit.

Once again, I hope that regulators will disclose more details about
what happened during those dark days.

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