Nasdaq default came at time of mass margin breaches

The default at Nasdaq Commodities in September 2018 occurred during a period when many clearing members incurred margin breaches, public disclosures show.

On September 11, lone trader Einar Aas was declared in default by the central counterparty (CCP) after failing to post sufficient margin to cover losses suffered from the widening of the spread between Nordic and German power futures. The default wiped out his initial margin, €7 million ($8 million) of Nasdaq's own capital and two-thirds of the default fund, for a total loss of €114 million.

But Nasdaq’s most recent CPMI-Iosco disclosures show that Aas was not the only member to trigger a breach in the third quarter. The CCP's energy clearing service reported 49 margin breaches at end-September, up from 20 three months earlier. The average size of the breaches reported in Q3 were €1 million – the largest since public disclosure began – and up from €77,951 at end-June 2018. 

The peak breach reported was €23 million in size, more than seven times larger than the previous largest peak breach reported in the fourth quarter of 2016. 

What is it?

Clearing houses that subscribe to disclosure rules set by international standard-setters CPMI-Iosco must disclose quarterly the number of times in the past 12 months that margin coverage held against any member’s account fell below the actual marked-to-market exposure of that account. They must also report the average and peak sizes of these uncovered exposures. Such an event is known as a margin breach as it implies the clearing member has not posted enough margin to the clearing house to cover its losses.

Why it matters

Nasdaq described the market movement that triggered the default as a true “black swan” event. As such, it would be expected that multiple clearing members would have wrestled with the positions that put paid to Einar Aas. The number of breaches reported in the third quarter reflects this.

But it appears as though it was the size of the breaches, rather than their frequency, that caused Nasdaq trouble.

The difference between the size of the peak breach and average breaches at end-September suggests most of the recent breaches were small in size. It is not clear whether the latest peak breach corresponds to the one that caused Einar Aas to default, and Nasdaq did not respond to a request for comment by press time, but its huge size makes it likely. The CCP did previously disclose that Aas’s position was not large enough to warrant concentration risk add-ons. 

Nasdaq also previously disclosed that the market move that triggered the default was 39% larger than the CCP’s margin model was designed to cover. The CPMI-Iosco disclosures show the achieved margin coverage level over the 12 months to end-September was 99.89%, down from 99.96% three months earlier.

This can be read two ways: on the one hand, margin coverage was robust even over a period of extreme stress. On the other, it took only the slightest dip in total margin coverage to wipe out the majority of Nasdaq’s default fund.

Small wonder then that Nasdaq’s risk management processes are under such scrutiny. In December, the Bank for International Settlements even released a report blasting the clearing house for myriad failures, saying “sound risk management and preparation make all the difference between a CCP that absorbs a shock and one that propagates it”. 

It is unlikely that this will be the last scolding Nasdaq receives, especially since much remains unknown about the circumstances that led to the default and how the fallout was managed.

This article was first featured on FX Week's sister site, Risk.net