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Lehman Brothers Jan 20
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Derivatives Clearing: Why Have Clients Lost Their Right To Claim For Losses?
Jan 18, 2016 | Lexology
...To give an example of how the concern arises (using Lehman Brothers to stand in for the client’s counterparty): Suppose a client enters into a single derivative with Lehman Brothers under a standard ISDA master agreement, and the derivative is not centrally cleared. The derivative is acting as a hedge for the client. Lehman Brothers defaults...
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Derivatives
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Derivatives Clearing: Why Have Clients Lost Their Right To Claim For Losses?
Jan 18, 2016 | Lexology
The standard documents in use for central clearing of OTC and exchange-traded derivatives in Europe oblige clients to surrender their normal contractual right to claim for compensation should their clearing member default. If following a clearing member default a client’s derivatives are terminated by the clearing house acting as central counterparty (the “CCP”), then instead of being able to claim for the cost of being put in the position that the client would have been in had the clearing member not defaulted, the client is obliged to accept a CCP valuation that does not take the client’s circumstances into account. This creates a significant risk of unrecoverable losses for clients, a result that is not needed for the proper functioning of the derivatives market and which may add to the inevitable market stress should a major derivatives clearing member default. This situation should be remedied by restoring within the industry standard documents the client’s right to claim for its full losses.
...THE PROBLEM CAUSED BY CLIENTS NOT HAVING THE RIGHT TO CLAIM FOR THEIR FULL LOSSES
The clearing documents provide that if a clearing member defaults and its clients’ cleared derivatives are terminated rather than porting to a new clearing member, when determining the amount that must be paid between the clearing member and a client for the terminated Client Derivative, the same value must be used as that which the CCP imposes on the clearing member for the CCP Contract4 . This use of the CCP valuation creates a risk of significant unrecoverable losses for clients if the porting process doesn’t succeed.
To give an example of how the concern arises (using Lehman Brothers to stand in for the client’s counterparty): Suppose a client enters into a single derivative with Lehman Brothers under a standard ISDA master agreement, and the derivative is not centrally cleared. The derivative is acting as a hedge for the client. Lehman Brothers defaults at a time when the derivative has a mark-to-market value close to zero. The derivative terminates. The client replicates the derivative with another dealer as it needs to replace the hedge. The other dealer charges $10 to replicate the derivative. The client is out of pocket $10. The client claims $10 from the Lehman Brothers insolvency using the normal ISDA master agreement closeout mechanism.Now suppose that the derivative with Lehman Brothers is cleared through a CCP with Lehman Brothers as clearing member, and Lehman Brothers and its client are using the new clearing documents5. Lehman Brothers defaults and the derivative is terminated rather than porting to a new clearing member. As before, the client replicates the derivative with another dealer, and pays the dealer $10 to do so. Separately, the CCP runs an auction among undefaulted clearing members to enter into a derivative with the CCP to replace the terminated CCP Contract equivalent to the Client Derivative6. The winning auction bidder requires $25 to enter into the replacement derivative with the CCP, which the CCP must pay. Under the clearing house rules the insolvent Lehman Brothers must pay the CCP $25 for the terminated CCP Contract. Under the clearing documents’ terms, the client must now pay Lehman Brothers $25 for the terminated Client Derivative. The client is now out of pocket $35, with no opportunity to recover from the insolvency estate.
The odd result of using the new clearing documents’ terms for valuing terminated cleared derivatives is that Lehman Brothers is effectively insulated from the losses that its own default causes. Lehman Brothers has escaped liability for the $10 of losses it caused the client, and can pass on to the client the $25 loss that Lehman Brothers’ default caused the CCP. Not only is this result not required by EMIR, it appears to run counter to the G-20 objective of reducing systemic risk in derivatives markets. It is contrary to normal contractual principles for claims for breach of contract and to the ordinary measure of creditor claims under bankruptcy law.
...POTENTIAL FOR SYSTEMIC HARM
More broadly, the obligation on a client to make an excessive payment to the insolvent clearing member has a needless negative impact on the financial system. In the example above, the $25 that the client has to pay the insolvent Lehman Brothers is cash that will not reappear until the bankruptcy estate makes a distribution in years to come. A major clearing member default would likely see the financial system in crisis, and in those circumstances the further loss of liquidity for the client and the market as a whole caused by excessive payments to the insolvency estate risks adding to the stress.
The potential for loss for clients between the price at which clearing members accept the risk of replacing terminated CCP Contracts through the CCP default auction process and the price at which a client is able to re-hedge the terminated Client Derivative should not be understated. The notional size of Lehman Brothers’ derivatives book has been estimated as being approximately $35 trillion at the time of default9. A CCP that needs undefaulted clearing members to take the market risk of a significant percentage of a large defaulted clearing member’s cleared derivatives in a time of system-wide distress would likely receive poor offers for replacement derivatives. Similarly a client seeking to re-establish a derivatives hedge immediately following its clearing member defaulting would face poor offers from dealers.
For full story: http://www.lexology.com/library/detail.aspx?g=ca37585b-e10c-4fc3-b1da-e293eaf5cc62
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Derivatives
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