Margin Focus in OTC Default Risk

Chidem Kurdas

When Lehman Brothers collapsed in 2008, LCH.Clearnet took over huge derivatives  positions from the bankrupt bank. The clearing house successfully managed this and four other defaults, says Isabella Kurek-Smith, director and head of energy and freight markets at LCH.Clearnet. The experience demonstrated how important it is to require adequate initial margin—though some derivatives traders complain of having to post collateral they regard as excessive.

Managing default risk and setting margins will be key to the success of swap clearing after the provisions of  Dodd-Frank that require most over-the-counter derivatives to be cleared go into effect.

LCH.Clearnet has a default fund that each clearing house member contributes to, said Ms. Kurek-Smith, speaking at a Capital Link Forum. But the Lehman positions were auctioned off without affecting the members. There was no need to draw on the default fund because the initial margin payments held by the clearing house were enough—there was even money left over that went back to the Lehman bankruptcy estate.

So setting margins is extremely important for the protection of a clearing house, she says. Margins being the first defense against losses in closing out defaulted positions, lowering them to get more business is dangerous, even as traders push to reduce the capital requirement.

Margins depend on market volatility. “If volatility is high, we’d be at a high price risk if we inherited positions and had to close them,” Ms. Kurek-Smith said. “So for everybody’s protection, we don’t compete on margins.”

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