European central counterparties (CCPs) are generally well equipped to manage extreme negative developments in the market, according to the European Securities and Markets Authority (ESMA) EU-wide stress test report.
In the first EU-wide stress test, ESMA assessed the resilience of CCPs to severe market shocks, and the potential impact this could have on their clearing members.
Under the European Market Infrastructure Regulation (EMIR), ESMA is required to identify any events that could exhaust the resources of CCPs, and to estimate whether such an event could have an adverse effect on the economy.
According to the report, CCPs would only struggle in the case of a number of clearing members defaulting at once during a period of severe market volatility.
The stress test included components of member default, historical variants, hypothetical variants, and reverse stress testing. The reverse stress test explored the number of entities that would have to default to exhaust the total resources of a CCP, also taking in to account the other three variants.
Although central counterparties were set up to reduce the systemic risk of bilateral counterparty relationships, because CCPs are highly connected through common clearing members, a default in a large member group could trigger default for other entities, exacerbating systemic risk.
According to ESMA, its tests in this area focused only on counterparty credit risk, and so were not necessarily adequate to establish the level of resilience. ESMA has pledged to improve its methodology in this area in future tests.
A high degree of concentration of mutualised resources was only found in one CCP, and in specific cases where high concentration resulted from small overall exposures to limited members. At a general EU level, however, ESMA found no sign of a high concentration either at a clearing member or group level.
The test found that pre-funded resources would be sufficient to cover losses, considering hypothetical and historical stress scenarios. In the case of these stress scenarios combined with the default of the top two clearing members, a CCP would have to call in additional resources up to an estimated amount of €1.4 billion, and this would leave uncovered losses of about €100 million.
However, this scenario is an extreme, unprecedented and implausible scenario, and the system was deemed, overall, to be resilient to such stress scenarios.
Reverse stress testing involved the hypothetical default of an extremely high number of entities, both EU-wide and at an individual CCP level.
The actual effect of this would not be limited to CCPs, ESMA said, and therefore cannot be accurately estimated. However, it assessed that the theoretical shortfall that CCPs could withstand is around €40 billion.
Finally, ESMA found that some CCPs were not applying stress price shocks representing the most extreme historic price changes given, while for some institutions that are sensitive to volatility shifts, some CCPs did not apply volatility stress scenarios.
The authority recommended that national competent authorities should ensure CCPs assess clearing partners for their credit-worthiness and the amount of losses other clearing members could be exposed to, because of participation in multiple CCPs.
ESMA also suggested that national competent authorities should supervise a review of price shocks applied in testing, and that CCPs should review their own stress tests, tailoring them to their specific offering based on historical and hypothetical scenarios.
The European Association of CCP Clearing Houses (EACH) welcomed the results. In a statement, EACH said: “The results indicate that, for the reporting dates, the system of European CCPs can overall be assessed as resilient to the scenarios used to model ‘extreme and plausible market developments’.”
Eurex Clearing has also welcomed the results. A spokesperson highlighted the findings around concentration and shortcomings in individual stress tests, saying: “The low level of concentration highlights the stability of the financial system. Based on our own calculations, Eurex Clearing shows one of the lowest concentration levels among all European CCPs.”
The spokesperson continued: “Eurex Clearing discussed minor inconsistencies with the minimum shifts with ESMA and the national competent authorities and took mitigating actions in order to be in line with the proposed minimum stress scenarios. The impact of these actions is not noticeable.”
Chair of ESMA Steven Maijoor said: “CCPs play a significant role in financial markets by reducing the exposure risk of clearing members. Therefore, ensuring that CCPs are resilient to shocks is an important supervisory tool to mitigate systemic risk.”
“ESMA’s first EU-wide stress test shows that European CCPs are overall well equipped to face the counterparty risk associated with the considered stress scenarios.”
