CCPs are well used to navigating severe market stresses and the occasional default of smaller clearing members. However, CCPs' resilience has not been tested by the ominous combination of highly volatile financial markets and the default of a sizable clearing member since Lehman Brothers defaulted in 2008--a test that the CCPs all passed. Nevertheless, since then, CCPs have continuously improved the quality of their risk management and the depth of the financial safeguards that protect them from the losses or illiquidity arising from such a scenario. Indeed, the leading global CCPs now assume the default of their two riskiest clearing members--a scenario that has not yet occurred.

Stress testing is therefore vital to effective CCP risk management. Such testing models extreme but plausible scenarios and ensures that the CCP has sufficient financial resources--primarily margins and default funds sourced from clearing members--to fulfil its contractual obligations even if key members default. While the CCPs are bound by a framework of regulations in this area, these regulations are not a straitjacket and they vary globally.

As a result, S&P Global Ratings observes significant differences among global CCPs' risk-management practices. They have similar but not identical objectives and layers of resources, but different asset classes and membership bases that pose different inherent risks. In addition, CCPs often have substantial latitude to develop their own models, assumptions, and processes to meet those objectives.

With this in mind, we view EU, U.K., and U.S. CCP supervisors' stress testing as highly valuable. They not only apply the stress tests consistently across the multiple CCPs that they oversee, but also deliver transparency and insights to the market through their reports on these exercises. We believe that this is particularly valuable in the EU because while the European Market Infrastructure Regulation sets a common standard across the union, the day-to-day supervision of CCPs is spread among many national competent authorities.

In our view, although the recent ESMA and Commodity Futures Trading Commission (CFTC) stress tests did not provide any transformational insights or highlight any deep concerns, we believe that some of their findings merit further exploration.

Rated CCPs have not yet faced the most nightmarish scenarios against which they seek to protect both themselves and their counterparties. However, our high ratings in the sector point to the generally good creditworthiness of the CCPs' largest members; their substantial protections to mitigate one or more member defaults; the rated CCPs' proven resilience in periods of high market stress; the demanding regulatory standards to which they are held; and the credible oversight by their supervisors.

ESMA's Stress Test Was Broad And Deep

Now in its fifth iteration, the breadth, depth, and methodological approach of ESMA's systemwide exercise continue to improve. The latest exercise was the most comprehensive so far, examining CCPs' resilience to:

• Counterparty credit risk losses arising from member defaults;
• Liquidity risk arising from having to complete trades when key members default, including when key liquidity disruptions occur;
• Client concentration risk; and
• Climate risk.

Consistent with the regulations, ESMA assessed the CCPs against a cover 2 standard for counterparty credit risk and liquidity risk--that is, assuming the default of the two riskiest members. The test covered 16 CCPs--14 in the EU, plus two Tier 2 CCPs in the U.K. that are categorized as systemically relevant in the EU (see table 1).

Table 1

In its assessment, ESMA principally used a multi-factor, hypothetical base adverse scenario set by the European Systemic Risk Board, but it also applied reverse stress tests to understand how CCPs' resource resilience fares when market parameters are subject to further shocks. We see the level of stress implied by this base adverse scenario as broadly comparable with that used in the Bank of England's (BOE's) ongoing stress test (see table 2).

Table 2

In our view, the outcomes of these types of stress test depend on the assumptions they make, not least on how much the risk parameters are stressed under the base scenario (see "ESMA's Stress Test Gives Clearinghouses Food For Thought," published Aug. 5, 2020). In ESMA's cornerstone assessment of counterparty credit risk, the modelling showed that no CCP would have used more than 50% of its default fund under the base scenario, let alone called on its members for fund replenishment.

In terms of liquidity risk, all CCPs had sufficient resources, and this remained true even with other disruptions layered on top. Notably, one of these disruptions was to exclude the CCPs' resources related to clients' excess margins--a sensibly cautious assumption in our view, and an area where CCPs' own standard assumptions vary. CCPs' resource usage varied significantly, as did their implied resilience when ESMA further stressed the liquidity outflows. This was largely because derivatives-centric CCPs typically have light liquidity demands (relative to the resources they hold), whereas cash/repo CCPs have high liquidity demands.

ESMA's climate risk analysis was exploratory. As we've noted previously, the climate transition offers both risks and opportunities to financial market infrastructure companies (see "ESG Industry Report Card: Financial Market Infrastructure Companies", published Dec. 3, 2020). In theory, CCPs and their exchange affiliates that have significant open interest in contracts with carbon-intensive underlyings such as oil and gas could be more exposed. However, if they develop broad energy- or commodity-centric franchises by building liquidity in new contracts aligned with the climate transition, the associated business risk appears less concerning.

Most pertinent, however, is ESMA's observation of CCPs' uneven implementation of climate risk scenarios in their market stress parameters. While implementation was strongest for commodity-centric CCPs, it remains an evolving area of risk management where all CCPs will likely need to step up further. All in all, business and clearing risks arising from climate change and the carbon transition will remain high on our agenda when monitoring the financial market infrastructure sector.

Among ESMA's other analyses and observations, we find the following particularly noteworthy:

Position concentration risk.   Ever since ESMA started to examine this risk in its third CCP stress test in 2020, it has made critical observations about how some CCPs handle the risk arising from concentrated client positions. Specifically, it has criticized the level of additional margin protection that CCPs call from their members due to the attendant high market impact and/or extended timeframe needed to liquidate those positions. It's an area where CCPs have substantial scope to devise their own techniques to mitigate the risk, leading to a natural diversity in practices and assumptions.

ESMA's analysis again implies some material gaps in CCPs' collected margins for such concentrations. While some of this stems from what we understand to be deeply conservative assumptions around position netting, it appears to be an area where some CCPs remain less conservative than others.

Ecosystem risk.  ESMA's network analysis shows a stark picture in commodities derivatives, where client clearing centers on a very small number of clearing members, particularly for gas contracts. In our view, this concentration has potential implications for default risk management if one of those clearing members fails, not least because it could be difficult for a CCP to undertake a substantial transfer of end-clients' positions to other members, leading the CCP to close out a substantial portion of open interest. Given that end-clients tend to have highly directional positions, this could have a significant impact on them and the broader market.

Investment risk.   ESMA observed that CCPs require much lower overcollateralization when they lend their cash under standard repo market terms, than when they clear trades in those same underlying securities. Since most European CCPs have depository access to their own central bank, this feature is most pertinent to CCPs that receive cash margins in U.S. dollars. While this is an insightful observation, it's unclear to us how these CCPs could further mitigate the already low attendant investment risk as they could not dictate substantially different repo contract terms to the rest of the market.

The CFTC's Narrower Stress Test Focused On Counterparty Credit Risk

Now in its fourth iteration, the concurrent CFTC exercise was--as in the past--narrower than ESMA's, focusing purely on a scenario-based analysis of the adequacy of CCPs' resources to absorb counterparty credit risk arising from member defaults. In this respect, it has a similar focus to the BoE's ongoing CCP stress test, on which it is due to report in the fourth quarter.

The CFTC's analysis covered nine derivatives-centric CCPs (DCOs), comprising 11 clearing services (see table 3). The CFTC took 11 historic market stress scenarios and explored the DCO's resilience by increasing both the severity of those scenarios and the number of assumed clearing member defaults. The CFTC then applied a reverse stress test.

Table 3

The CFTC's main conclusion is that "all individual DCOs are well capitalized to withstand multiple defaults, concurrent with extraordinarily large market shocks". DCO resource adequacy is evidently more sensitive to the size of the market movement than to the number of clearing member defaults.

Given that most of these historical scenarios date from recent years, we find it unsurprising that DCOs would likely have sufficient resource to cope with them. To a large extent, CCPs' antiprocylical measures should ensure that these movements are substantially (though not totally) captured in required margins, let alone needing the fallback reliance on default funds. Nevertheless, for future and options DCOs, it would seemingly take a 2x-4x increase in the historic market movements to fully deplete the paid-in default funds if two clearing members defaulted. For interest rate swaps, credit default swaps, and forex derivatives it would take an increase of at least 4x or more to deplete the paid-in default funds.

In contrast to the previous versions of its stress test, the CFTC also analyzed the interconnectedness in the derivatives clearing system arising from common members clearing at multiple CCPs. This is relevant as interconnections could potentially translate into simultaneous defaults across CCPs.

Leaving aside the most implausible scenarios, such as very high multiples of historic market movements, the CFTC concluded that a scenario that was most stressful for one CCP was not necessarily stressful for the other CCPs. Likewise, the losses clearing members suffer at one CCP are not the same as the losses they suffer at the other CCPs. The systemic risk from interconnectedness therefore appears to be relatively muted.

CCPs Are Central To Financial Stability, And Vice Versa

The recurring CCP stress tests by the BOE, the CFTC, and ESMA are not the only exercises that provide systemwide oversight. Two further exercises offer a useful adjunct:

• The CCP international default simulation exercise led by the Global Association of Central Counterparties in 2023. This exercise focused more on simulating a default scenario than on mathematical modelling. It was novel in its scope, covering 32 leading global CCPs and other stakeholders. It focused on the hypothetical default of a "clearing member everywhere"--that is, a global systemically important bank-sized entity that is one of the largest clearing members for each of the CCPs. It looked at the potential for operational stress, or a complex interplay of actions, as each CCP risk-managed the default. The exercise highlighted challenges in areas such as communication, stress on members from CCPs' multiple demands on them, the auction process, and client porting.
• The BOE's ongoing systemwide exploratory scenario, launched in 2023. This scenario encompasses the whole ecosystem of financial institutions--banks, insurers, CCPs, and various types of funds--to understand their behavior during stressed financial market conditions and how this might amplify shocks in the domestic financial markets that are core to the U.K.'s financial stability.

We view favorably this intensity of supervisory oversight and steady broadening of scenario analysis beyond individual CCPs to better understand the effects of their linkages with their ecosystems. When these exercises reveal pockets of potential weakness, as they inevitably will, we expect that policymakers will then act to mitigate them. CCPs are not risk-free, and irrespective of their strengths in risk management, their resilience hinges in part on the degree of risk inherent in the financial systems they serve.

Furthermore, the actions that CCPs may take to protect themselves in stressed markets may only aggravate an already fraught situation. Such actions include hiking margins, calling on contingent liquidity facilities, closing out house and client portfolios when members default, calling for additional default fund contributions, or enforcing contractual rights to terminate contracts. However, taken together, these systemwide exercises support our view of the low risk that clients face when they contract with the CCPs that we monitor.

Related Research

• FMIs' All-Weather Business Models Support Stability In 2024, Jan. 25, 2024
• ESG Industry Report Card: Financial Market Infrastructure Companies, Dec. 3, 2020
• ESMA's Stress Test Gives Clearinghouses Food For Thought, Aug. 5, 2020

Related External Publications

• Final Report: Fifth ESMA Stress Test Exercise for Central Counterparties, European Securities And Markets Authority, July 9, 2024
• Supervisory Stress Test of Derivatives Clearing Organizations: Reverse Stress Test Analysis and Results, Commodity Futures Trading Commission, July 1, 2024
• 2023 CCP Global International Default Simulation (CIDS) Exercise Report, Global Association of Central Counterparties, May 21, 2024
• Key Elements of the Bank of England's 2024 Supervisory Stress Test of Central Counterparties, Bank of England, April 19, 2024
• Bank of England launches first system-wide exploratory scenario exercise, Bank of England, June 19, 2023
• Adverse scenario for the European Securities and Markets Authority's 2023 central counterparty stress test, European Systemic Risk Board, May 31, 2023