Protection in a default

How does a Clearing House protect the market and other members when one member defaults? The answer is layers of defence, pools of assets to pay out against losses by the defaulting member.

Should there be a belief that a member is likely to default, the risk committee in the clearing house will meet to make a determination on whether that event has occurred. The process following a decision to place a member into default looks like this:

• Default declared by the clearing house
  
• The members account is locked to prevent any new trades being accepted
• The default management team is activated
• The team will attempt to reduce the market risk on the defaulters portfolio to minimise value swings from day to day. This means putting on trades to offset the risk in the portfolio, sometimes at off-market prices.
• The team will then auction the defaults portfolio to remaining members who are obliged to participate in the auction
• The assets held as VM, IM and the defaults Default (or Guarantee) Fund Contribution are used to pay for the risk reduction and auction activities

In 2008 the default of Lehman Brothers required LCH to process ~66,000 rate swap trades and consumed 35% of their collateral assets. You can read more on this topic at the LCH website here.