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Nasdaq Clearing

Counterparty Risk Management

Counterparty Risk Management

Nasdaq Clearing handles traditional business risks, as well as specific risks that are unique to the derivative clearing services it provides. The most noteworthy of these risks, with respect to the risk of loss, is counterparty default, i.e. the risk that one or several market participants will default on their obligations to the clearing organization. 

The ability of Nasdaq Clearing to manage overall counterparty risk is dependent upon several factors, including:

  • The Quality and Controls of the Overall Clearing Operations
  • The Quality and Controls of the Collateral That is Pledged by Participants
  • A Sound Legal Foundation (established Rules and Regulations)
  • Proactive Risk Management
  • The Financial Strength of The Clearing Organization As Evidenced By Its Capital Resources & Financial Liquidity

Nasdaq Clearing relies on a multi-asset risk system, Genium Risk, and customized margin methodologies per individual asset class. The margin calculation determines the appropriate amount of required collateral to compensate for the counterparty risk it assumes in its capacity as a clearing organization. The validity of the margin methodologies is supported by comprehensive testing program including regular margin back testing, model testing and sensitivity testing. The margin models are also subject to annual validation by external parties. 

Nasdaq Clearing also relies on a proprietary capital-at-risk calculation model and system (CCaR) to serve as the main driver in establishing an appropriate level of default fund and overall clearing capital. CCaR generates implied “loss given default” calculations based on extreme stress counterparty default assumptions. These are well defined, extreme stress, risk parameter assumptions applicable to an extensive range of market price movement scenarios along with well defined counterparty default assumptions. Also the CCaR model is subject to regular testing and an annual validation of external party.

Counterparty Risk

Counterparty risk is the risk that one party in a transaction will not be able to fulfill its obligations. In return for collateral, the clearing organization assumes the obligations under each derivative contract that has been accepted, thus minimizing the counterparty risk. Nasdaq Clearing therefore enters as counterparty for both the buyer and the seller. 

Nasdaq Clearing collateral requirements are calculated based on the specific counterparty’s trading positions. The collateral requirements are determined by risk models used to calculate an individual counterparty’s daily margin requirements and intraday margin calculations. The risk models and methodologies applied within Nasdaq Clearing have been specifically designed by the Clearing Risk Management department to address near worst-case scenarios. In a clearing structure where the member clearing model is applied, the end-customer has a risk towards the member as the end-customers do not have a direct legal relationship with the clearing organization. 

In a clearing structure where the end-customer clearing model is applied, the end-customer has a limited counterparty risk towards the clearing member because the end-customer has a direct relationship with the clearing organization. 

Nasdaq Clearing always acts as seller to the buyer and as buyer to the seller which is why its portfolio is perfectly matched. Market risk, which is defined as the risk of loss from fluctuations in market price, is maintained at zero unless a counterparty defaults on its obligations or if operational errors occur that affect the balanced position of Nasdaq. If market risk occurs because of an operational error, the internal operational procedure is to close down the position immediately to minimize the potential market risk. Counterparty default events are managed by the Nasdaq Clearing Default Committee.

Clearing Risk Management Department

The Clearing Risk Management department within Nasdaq Clearing is primarily responsible for professionally managing counterparty risks. This is accomplished through a comprehensive counterparty risk management framework made up of policies, procedures, standards and resources. These resources are human, informational and technological. These resources and the framework that is applied are essential to the accurate measurement, reasonable control and desired level of protection from all identifiable counterparty risks, as well as all operational risks arising within the Risk Management’s scope of responsibility. The framework is also designed to meet the counterparty risk management and related corporate governance objectives of Nasdaq Clearing. 

The day-to-day work is dedicated to achieving the following goals:

  • Asses and manage the counterparty risk associated with Nasdaq Clearing's existing and/or new products and services 
  • Ensuring that executive management and relevant Boards of Directors are appropriately informed of all significant counterparty risk control issues which occur 
  • Maintaining compliance with international industry standards specific to risk management 
  • Making continuous improvements to the Nasdaq Clearing counterparty risk management framework The Clearing Risk Management department manages changes in counterparty risk exposures against a range of risk limits on a daily and intraday basis.

The Clearing Risk Management department relies on well established margin methodologies, which are validated regularly by automated margin back testing. The Clearing Risk Management department also monitors and responds to noteworthy changes in risk exposure and changes in the financial markets, which can affect the risk profile of the counterparties.
The Clearing Risk Management department responsibility also includes:

  • Screening of the creditworthiness and financial performance capacity of:
    – Applicants seeking approval as Clearing Members
    – Custodian Institutions
    – Settlement banks
  • Monitoring the performance capacities of the above referenced counterparties
  • Ensure effectiveness and constantly improve and develop its default management routines and processes
  • Responding to Regulatory Authority and other significant stakeholder inquiries concerning the Derivatives Markets’ counterparty risk management framework 
  • Providing analysis and recommendations on counterparty risk issues relating to Nasdaq Clearing's business development initiatives

Risk Management Procedures

The following procedures within the Clearing Risk Management department are worthy of specific emphasis and comment: 

  • Procedures for Handling Parameter Breaks 
  • Intraday Risk Reporting and Monitoring 
  • Intraday Margin Calls 
  • Blocking of Trades and Offsetting Trades

Parameter Breaks
Each morning, the Clearing Risk Management department is made aware of any risk interval parameter breaks, or situations where the change in day-to-day market prices has exceeded the approved risk interval parameter level for any underlying security. The following is tracked when a parameter break occurs: 

  • The day-to-day price movement of the underlying security that has resulted in a parameter breach 
  • The approved parameter of the underlying security 
  • The change in price relative to the parameter 
  • The volume of outstanding contracts for the respective underlying product 

When a risk interval parameter break occurs, the respective affected counterparty accounts are reviewed in detail, the cause of the price movement is also reviewed and a decision is taken by the Clearing Risk Management department as to what action, if any, is required, immediately or during the course of the day in response. 

It is important to note that, from a statistical standpoint, risk interval parameter breaks are an expected phenomenon, due to the fact that a statistical numerical probability of less than 100 percent is used for calculating appropriate risk parameter intervals and/or that the volatility has increased compared to the applied look-back period. It is also worth noting that if there has been a break in a risk interval parameter, it does not necessarily signify an automatic need to change the parameter. What it indicates instead is a need to evaluate the positions of the counterparties that are affected and to evaluate the overall impact of the parameter break on the collateral position of the counterparty accounts that are affected. Typically, accounts will have diversified portfolios and such diversification helps to mitigate the effects of the risk interval parameter breaks in individual instruments. 

Intraday Risk Monitoring
Intraday risk reports are generated every hour (starting at CET 10:00 and ending at CET 18:00) or more often if deemed necessary. Each intraday margin calculation reflects any clearing participant’s change in exposure, with updated positions and real time prices, during the clearing day. In case of a breach by a participant of the intraday risk limit, the Clearing Risk Management will issue a margin call. 

Different types of risk limits and alarms are established by the Clearing Risk Management department. It is also worth noting that breaching of a risk limit is not grounds for default; it simply serves as one of many early warning measures applied by the Clearing Risk Management department.

Intraday Margin Calls
Nasdaq Clearing has both the authority and the capacity to calculate and require intraday margin as a means of maintaining a desired level of margin coverage. The Rules and Regulations of Nasdaq stipulate that the new margin requirement shall enter into force immediately and be met by the member no later than 90 minutes after the clearing house notified the clearing member that a new margin requirement has been calculated. 

Blocking of Trades and Offsetting Trades
Excluding default events (covered under Default History section of this document), Nasdaq Clearing has not found it necessary to exercise its right to block the trades of any counterparty since 2000. There have been instances where counterparties have been contacted and instructed to discontinue any additional trades in a given instrument in order to limit the concentration risk of a specific position, or to prevent an increase in a position of the counterparty in question. In all such instances, the counterparties have complied and cooperated in full with Nasdaq Clearing’s instructions. 

There have also been instances where counterparties have been requested by the Clearing Risk Management department to offset trades to reduce the current margin requirement to a level where the counterparty is capable of delivering margin.

Nasdaq Clearing Counterparty Risk Management Framework

The following depicts the overall counterparty risk management framework that the Clearing Risk Management department applies in its approach to managing counterparty risk within Nasdaq Clearing. This overall framework is purposely designed to incorporate continuous improvement to the methods used in professionally managing counterparty risk. 

Counterparty Risk Management Framework

With respect to the due diligence review of this framework, it is worth noting that the Clearing Risk Management department—and the framework which it applies—is subject to comprehensive (typically annual) due diligence reviews from a broad range of stakeholders including the Board of Directors, regulatory authorities, internal auditors, external auditors and rating agencies.

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