CCP Default Management

This content is used in work that checks how a clearing member prepares for default, and in work where members estimate the CCP's default waterfall.

What a CCP does when a member defaults

A central counterparty (CCP) sets out in its rules what it does when a clearing member defaults. How a CCP works is covered on the Central Counterparties: JSCC, LCH, CME and Others page.

"CCP default management" combines two situations. Below, "default handling by the CCP" means the processing of positions and the allocation of losses that a CCP carries out when a member defaults. "Resolution of the CCP itself" means the response by the authorities when the CCP itself can no longer continue.

The Principles for financial market infrastructures (PFMI) give the aims of default handling as follows. They include completing settlement on time even in extreme market conditions, minimizing losses to the CCP and to non-defaulting members, and limiting market disruption¹. The PFMI as a whole are covered on the Overview of Market Infrastructure page.

Japan Securities Clearing Corporation (JSCC) declares a clearing member in default through its management when the member is unable to perform its obligations or is likely to be unable to. Once it declares a default, JSCC stops accepting new trades, processes the defaulting member's positions and fixes the loss². The PFMI say the rules should make clear whether a declaration is automatic or a matter of discretion, and who exercises that discretion³.

The way positions are processed differs by product. For listed products, JSCC's basic approach is to liquidate or offset positions in the market, and it also uses hedging trades and default auctions depending on the makeup and size of the positions and on market conditions. Credit default swaps (CDS), interest rate swaps, and over-the-counter Japanese government bond (JGB) transactions are processed through an auction in which non-defaulting members take part. For CDS and interest rate swaps, JSCC hedges the defaulting member's positions immediately so that losses do not grow before the auction. It takes advice from the advisory committee of each clearing service (the CDS default management committee and the interest rate swap default management committee)². This default auction is separate from the auction that sets a settlement price after a CDS credit event.

Figure description

This diagram shows how a CCP processes CDS and interest rate swap positions when a member defaults. First, the CCP declares the default and stops accepting new trades. After the declaration, two things run in parallel. The CCP hedges the positions, and customers may move their own positions to another member, which requires the receiving member's acceptance. After the hedge, the non-defaulting members take part in the auction of the positions, and finally the CCP fixes the loss and covers it in the default waterfall order. The CCP declares the default, hedges and fixes the loss, the non-defaulting members take part in the auction, and customers handle the move. The point to take from the diagram is that hedging limits the growth of losses before the auction handles the positions, while the move of customer positions proceeds as a separate flow.

The PFMI expect a CCP to have tools for disposing of a defaulting member's positions quickly. These include hedging methods as an interim measure when positions cannot be disposed of immediately, and rules that state clearly the scope and the participants' obligations if positions are put up for bidding⁴. For CCPs clearing over-the-counter derivatives, it may be necessary to consider a procedure for asking non-defaulting participants to take an allocation of the portfolio if the bidding fails. The PFMI add that the risk to the participants who would receive an allocation should be considered carefully in advance⁵.

For JSCC's clearing of listed derivatives, CDS and interest rate swaps, customer positions can be moved to another member without the consent of the defaulting member. The receiving member's acceptance is required. For JSCC's cash market transactions, JSCC does not hold the customer positions and margin that would be moved⁶. JSCC maintains a liquidity facility that raises temporary funds so that it can settle on the normal schedule even if a member defaults².

In what order losses are covered

The order in which a CCP uses the resources that cover the losses from a member's default is called the default waterfall. It can include the defaulting participant's initial margin, the defaulting participant's contribution to the default fund, a specified part of the CCP's own financial resources, and the non-defaulting participants' contributions to the default fund⁷. The general form is to use the assets provided by the defaulting participant first, which gives participants an incentive to manage risk prudently. The PFMI say the order of use should be set in the rules so that participants can estimate their future obligations⁸.

JSCC's basic approach is to cover losses first with the defaulting member's resources (margin and so on) and then with the non-defaulting members' resources (the default fund and so on). To keep the CCP's incentive to manage risk properly, however, JSCC places its own contribution ahead of the non-defaulting members' contributions⁹. JSCC builds this arrangement for each clearing service so that a loss in one service does not reach the others⁹.

Consider a hypothetical example in which H Co. defaults and the processing of its positions fixes a loss. H Co.'s margin and default fund contribution total 8 billion yen (7 billion yen of margin and a 1 billion yen default fund contribution), the CCP's own resources are 1 billion yen, and the non-defaulting members' default fund totals 20 billion yen. The table compares three cases, with losses of 8 billion, 15 billion and 33 billion yen. The amounts are not the actual figures of any CCP.

With a loss of 8 billion yen, H Co.'s resources alone cover it and the other members bear nothing. With 15 billion yen, the shortfall of 6 billion yen after H Co.'s 8 billion yen and the CCP's 1 billion yen comes from the non-defaulting members' default fund. With 33 billion yen, the pre-funded resources of 8 + 1 + 20 = 29 billion yen are used up, and 33 − 29 = 4 billion yen remains. How the remaining 4 billion yen in the 33 billion yen case is handled is covered in the section "When pre-funded resources are not enough."

The size of the pre-funded resources depends on the defaults the CCP assumes. For many of its services, including cash market transactions, CDS and interest rate swaps, JSCC sizes its default fund on the assumption that the top two clearing members (including their affiliates) default. For commodity futures and similar products (excluding crude oil futures and similar), the assumption is that several members default, including the top one¹⁰. Whether the resources are enough is checked by stress testing at least once a day⁹.

The CCP's own resources and differences among CCPs

An arrangement in which a CCP uses its own resources to cover losses is called skin in the game. In its February 2021 consultation, HM Treasury says that in the rulebooks of UK CCPs, a part of the CCP's own capital sits before the pre-funded default fund. It comes after the defaulting member's initial margin and default fund contribution. This creates an incentive for the CCP to manage risk properly¹¹. The amount is set as a multiple of the CCP's minimum capital¹². The same document also sets out a proposal to put in the rules a second CCP fund, to be used after the pre-funded default fund and before additional contributions¹³.

The table below compares three sources. The UK column reflects the February 2021 consultation and does not reflect later changes to the regime.

The treatment of losses across services can also differ among CCPs. When a CCP operates in several markets, the PFMI say that using resources provided by participants in one market to cover a default loss in another is appropriate only under three conditions. The conditions are a sound legal basis, clarity to all participants, and the ability to avoid the risk of contagion between markets and participants¹⁶. As seen above, JSCC contains losses within each service.

When pre-funded resources are not enough

A loss can remain after the pre-funded resources are used up. The PFMI say that in extreme conditions, selling collateral and other assets may not cover a credit exposure loss in full, so a CCP should set out in its rules and procedures how uncovered losses are allocated. This includes repaying funds borrowed from those who provided liquidity¹⁷. Allocation methods include allocating uncovered losses to the unrealized gains of non-defaulting participants, and asking for additional contributions in line with the size or risk of each participant's portfolio¹⁸.

In Japan, the Financial Services Agency's supervisory guidelines make it a point of focus for a CCP whether its business rules and similar documents clearly set out the power to collect additional contributions, and the allocation method, when losses exceed the pre-funded resources¹⁹. The PFMI also say the rules should set out how used resources are replenished. They should state that non-defaulting participants have an obligation to replenish used resources and that participants can anticipate the period over which they must do so⁸.

When the CCP itself cannot continue

The PFMI say that even after every preventive measure, there may be extreme situations in which a CCP can no longer continue as a going concern or becomes insolvent. A disorderly failure is likely to disrupt the financial institutions and markets it serves, linked financial market infrastructures and the financial system as a whole²⁰. The responses are recovery, which keeps critical operations and services running, and an orderly wind-down, such as transferring the operations of a CCP that cannot continue to another entity. The party that carries them out can be the CCP itself, the authorities, or both²¹. Recovery tools include recapitalization, replacement of management, merger with another financial market infrastructure, a review of business strategy, and restructuring of services²².

The response by the authorities among these is the resolution of the CCP itself. The PFMI cited here and the guidance of the Financial Stability Board (FSB) are international frameworks. The powers the FSB guidance lists do not necessarily apply to JSCC as they stand.

On July 5, 2017, the FSB published guidance on the resolution of CCPs and resolution planning. It helps authorities plan the resolution of a CCP itself. Its aims are to maintain financial stability, to continue critical functions, and to avoid exposing taxpayers to the risk of loss²³. The guidance is not legally binding, and the powers of the authorities are set by the legal framework of each jurisdiction²⁴²⁵. What follows describes the contents of this guidance.

The guidance says resolution authorities need the following powers²⁵.

• Enforcing contractual obligations
• Temporarily running the CCP
• Returning to a matched book (one in which buys and sells balance) after a member's default has thrown the book out of balance
• Dealing with unallocated losses and replenishing resources
• Writing down the CCP's equity and some of its liabilities
• Transferring critical functions to a third party or a bridge CCP (a CCP set up by the authorities to take over the transferred functions)
• Winding down non-critical operations

The guidance says that for losses from a member's default, the authorities should in principle continue the procedures in the CCP's rules even if they step in before those procedures are exhausted. It says they may depart from the rules, however, within clear limits and with safeguards, if that is necessary to avoid a material adverse effect on the financial system²⁶.

The point at which authorities can start the resolution of a CCP itself is not limited to the time when recovery tools have been used up. Authorities should be able to start resolution when the CCP has not returned to viability after recovery tools are used up, or when they judge that it will not do so within the necessary time²⁷. In the resolution of the CCP itself, the CCP's equity should absorb losses in full. When the write-down happens must be clear and transparent. One form is a point no later than when pre-funded resources and the additional contributions in recovery are exhausted²⁸. The guidance calls for plans for the resolution of a CCP itself that do not rely on public funds. Even in jurisdictions where public funds can be used, it calls for them to be a last resort for a limited period, and recoverable from the CCP's assets, its participants, and others²⁹.

Deep diveTear up and variation margin gains haircutting

The guidance lists calls for voluntary action, auctions and tear up as means for the resolution authority to restore a matched book. Tear up means settling and extinguishing contracts without reopening them. Doing so for some contracts is called partial tear up, and for all contracts, complete tear up³⁰³¹.

Partial tear up can be considered only in the following cases. These are when market-based tools (an auction or a direct disposal in the market) have failed or are expected to fail, when losses beyond the pre-funded resources are expected, or when financial stability would be harmed. Tear up is used to restore a matched book, not to allocate losses³². Complete tear up should be avoided as far as possible³³.

Variation margin gains haircutting means reducing the variation margin a CCP pays to participants, to the extent of the gain in value of their positions since a specified point. Participants whose positions fell in value keep paying variation margin in full³¹. Where relevant, the authorities should have this power³⁴.

On November 16, 2020, the FSB finalized its guidance on assessing the adequacy of resolution resources and on the treatment of equity in resolution³⁵. On April 25, 2024, it published a report on resources and tools for the resolution of systemically important CCPs³⁶. The report expects authorities to be able to use dedicated resolution resources and tools, combined from a list of seven resources and tools, and expects each jurisdiction to make transparent how their size is decided. They need not have all seven, and no single resource or tool is sufficient on its own³⁷.

Thinking about loss allocation and additional contributions

The FSB guidance says participants, shareholders, and creditors should have a right to compensation. It applies if they receive less than they would have received had the CCP been liquidated under insolvency law or similar. This is a protection for when authorities depart from the allocation in the rules in the resolution of a CCP itself. The liquidation assumed for that comparison applies all of the CCP's loss allocation rules³⁸. Authorities should also not discriminate on the basis of nationality when they depart from the rules²⁶.

Additional contributions can be asked of members when losses exceed the pre-funded resources. Even where the law gives authorities the power to require additional contributions, the guidance assumes that this power is used only after the pre-funded order is exhausted, and that members can estimate their maximum contribution at any time³⁹. A PFMI footnote says that increasing resources whose losses are shared mutually makes it easier for a CCP to prepare for a default in extreme conditions, but also raises the interdependence of participants. It asks for a balance with resources kept separately for each participant, such as margin, to limit systemic risk⁴⁰.

The example in the table is a simplification for understanding the order. The actual order and amounts are set in the rules of each CCP and each clearing service.

The February 2021 HM Treasury consultation includes a proposal to place a second CCP fund after the pre-funded default fund (see "The CCP's own resources and differences among CCPs"). In that case, the 4 billion yen "shortfall against pre-funded resources" in the 33 billion yen case in the table would first be allocated to the CCP's second fund in the order.

What this page does not cover

The details of the default waterfalls of LCH and CME are not covered on this page.

The content of the Japanese laws on the resolution of a CCP itself that apply to Japanese CCPs is not covered on this page.

HM Treasury's March 2022 response indicates an intention to introduce the second fund⁴¹. Later legislation is not covered on this page.

Notes

1. CPSS-IOSCO, "Principles for financial market infrastructures" (April 2012), paragraph 3.13.1 (pages 110–111 of the Japanese provisional translation, in Japanese). ↩

2. Japan Securities Clearing Corporation, 参加者破綻処理 (shown as of February 13, 2018; in Japanese), main text. ↩ ↩² ↩³

3. "Principles for financial market infrastructures" (Japanese provisional translation), paragraph 3.13.2 (page 111). ↩

4. "Principles for financial market infrastructures" (Japanese provisional translation), paragraph 3.13.4 (pages 112–113). ↩

5. "Principles for financial market infrastructures" (Japanese provisional translation), footnote 117 to paragraph 3.13.1 (page 111). ↩

6. Japan Securities Clearing Corporation, リスク管理 分別管理・勘定移管 (shown as of April 14, 2023; in Japanese), section ポジション及び証拠金の移管. ↩

7. "Principles for financial market infrastructures" (Japanese provisional translation), paragraph 3.4.17 (pages 57–58). ↩ ↩²

8. "Principles for financial market infrastructures" (Japanese provisional translation), paragraph 3.13.3 (pages 111–112). ↩ ↩²

9. Japan Securities Clearing Corporation, リスク管理 損失補償 (shown as of October 1, 2026; in Japanese), main text. ↩ ↩² ↩³ ↩⁴

10. Japan Securities Clearing Corporation, リスク管理 清算基金 (shown as of September 21, 2021; in Japanese), main text. ↩ ↩²

11. HM Treasury, "Expanded Resolution Regime: Central Counterparties" (February 2021), Annex A, paragraph A.47 (page 18). ↩ ↩²

12. HM Treasury, "Expanded Resolution Regime" (February 2021), Annex A, paragraph A.48 (page 18). Records that the amount is set as a multiple of minimum capital. ↩

13. HM Treasury, "Expanded Resolution Regime" (February 2021), Annex A, paragraphs A.49 and A.50 (page 18). ↩

14. HM Treasury, "Expanded Resolution Regime" (February 2021), paragraph 1.10 (page 3). ↩

15. "Principles for financial market infrastructures" (Japanese provisional translation), Principle 4, key consideration 4 (page 48). ↩

16. "Principles for financial market infrastructures" (Japanese provisional translation), paragraph 3.4.24 (page 61). ↩

17. "Principles for financial market infrastructures" (Japanese provisional translation), paragraph 3.4.25 (page 62). ↩

18. "Principles for financial market infrastructures" (Japanese provisional translation), footnote 61 to paragraph 3.4.25 (page 62). ↩

19. Financial Services Agency, 清算・振替機関等向けの総合的な監督指針 (in Japanese), III-3-5, （2）主な着眼点. ↩

20. "Principles for financial market infrastructures" (Japanese provisional translation), paragraph 1.24 (page 19). ↩

21. "Principles for financial market infrastructures" (Japanese provisional translation), paragraph 1.25 (page 19). ↩

22. "Principles for financial market infrastructures" (Japanese provisional translation), footnote 135 to paragraph 3.15.5 (page 126). ↩

23. Financial Stability Board (FSB), "Guidance on Central Counterparty Resolution and Resolution Planning" (July 5, 2017), section 1 (page 2). ↩

24. FSB, "Guidance" (July 5, 2017), the statement on the non-binding nature of FSB work on page ii. ↩

25. FSB, "Guidance" (July 5, 2017), the opening of section 2 (page 3). ↩ ↩²

26. FSB, "Guidance" (July 5, 2017), paragraph 2.2 (pages 3–4). ↩ ↩²

27. FSB, "Guidance" (July 5, 2017), the opening of section 3 and paragraph 3.1 (pages 6–7). ↩

28. FSB, "Guidance" (July 5, 2017), paragraph 4.1 (page 9). ↩

29. FSB, "Guidance" (July 5, 2017), paragraphs 6.5 and 6.6 (page 13). ↩

30. FSB, "Guidance" (July 5, 2017), paragraph 2.3 (page 4). ↩

31. FSB, "Guidance" (July 5, 2017), "Key Terms," entries "Tear up" and "Variation margin gains haircutting" (pages 22–23). ↩ ↩²

32. FSB, "Guidance" (July 5, 2017), paragraphs 2.4 and 2.5 (page 4). ↩

33. FSB, "Guidance" (July 5, 2017), paragraph 2.6 (page 4). ↩

34. FSB, "Guidance" (July 5, 2017), paragraph 2.10 (page 5). ↩

35. Financial Services Agency, announcement of the FSB's "Guidance on Financial Resources to Support CCP Resolution and on the Treatment of CCP Equity in Resolution" and further work (provisional translation, November 16, 2020; in Japanese), main text. ↩

36. Bank of Japan, announcement of the FSB's publication on resources and tools for the resolution of central counterparties (in Japanese), main text. ↩

37. Financial Stability Board, "FSB introduces new global standard to support the orderly resolution of a central counterparty (CCP)" (Ref: 9/2024), the two expectations in the main text. ↩

38. FSB, "Guidance" (July 5, 2017), the opening of section 5 (page 10). ↩

39. FSB, "Guidance" (July 5, 2017), paragraph 2.9 (page 5). ↩

40. "Principles for financial market infrastructures" (Japanese provisional translation), footnote 54 to paragraph 3.4.18 (page 58). ↩

41. HM Treasury, "Expanded Resolution Regime for Central Counterparties: Government Response to Consultation" (March 2022), pages 17–18. ↩