Our risk management philosophy
As part of the clearing house services offering, LCH is responsible for risk management. This involves day-to-day risk management of cleared products, margining of clearing members’ positions, margin models, setting and analysing margin parameters, daily member-level monitoring, and potentially intra-day margin calls.
To be confident that it can maintain the safety and stability of clearing members and clients, our DigitalAssetClear service has built a framework of safeguards, underpinned by state-of-the-art risk models.
These various layers of protection work in concert to ensure that LCH has adequate financial resources to fulfil these obligations in all circumstances – most importantly, to protect cleared trades at our clearing house and the collateral posted against them.
Safety and stability: risk management at DigitalAssetClear
Risk management and settlement is at the core of everything we do here at DigitalAssetClear.
It starts with the onboarding process, where we assure that a new Clearing Member has the capabilities to participate in the market and manage their positions.
That philosophy then runs through every step of DigitalAssetClear clearing process and all the way to the management of a Clearing Member default.
Membership criteria
As our first line of defence, DigitalAssetClear sets stringent and transparent eligibility requirements for prospective Clearing Members.
Find out more about our membership requirements
The Margin Framework
A comprehensive Margin framework covers the Initial and Additional Margin requirements, the mark-to-market in the form of Variation Margin.
Initial and Additional Margin
The financial risks associated with the closeout of a member’s position are covered through the Initial Margin and Additional Margins. The core Initial Margin (IM) uses an analytical (VAR/Expected shortfall) model to measure the potential loss distribution of DigitalAssetClear positions.
Additional Margin (AM) covers various forms of risks such as concentration risk, expiry risk and positions with high-stress losses compared to the mutualised resources.
Variation Margin
In addition to IM, we also collect daily Variation Margin (VM) from all counterparties to account for changes in the mark-to-market value of DigitalAssetClear positions.
By collecting VM, we ensure that all our members are up-to-date with all their obligations which prevent default scenarios where member losses could have accumulated over a prolonged period of time.
Our Margin Simulator
The DigitalAssetClear Margin Simulator allows you to estimate your level of margins on effective and hypotethical positions and to optimise your clearing strategy. It offers outstanding insights on margin requirements and provides real-life simulation of margin efficiency.
Default management
In the event of a Clearing Member default, these pre-emptive safeguards dramatically limit the impact arising from the default (Defaulter pays principle). The defaulted portfolio of listed contracts could be hedged or traded out with the guidance of the Default Management Group to reduce its risk, and then auctioned off.
Default fund
In addition to IM and AM, the Clearing Member contibutes to the Default Fund a mutualised ressource to cover member default. The Default Fund is sized to cover a default of the two highest members’ group exposures and the clearing member is required to contribute at minimum to a floor amount.
In the next section, we go into more detail about precisely how we would manage a member default.
Default management process
LCH maintains a rigorous default management process. The process is tested regularly in Firedrills which involve members.
DigitalAssetClear default management process follows three key steps to ensure the smooth resolution of the failure while minimising any impact from the default on surviving Clearing Members and their clients.
Risk neutralisation and client porting: After a clearing member default, the defaulter’s portfolio is traded out or hedged with the assistance of our DigitalAssetClear Default Management Group, made up of internal and external participants that are seconded to LCH in the event of default.
Alongside this, DigitalAssetClear begins the process of attempting to port clients to non-defaulting clearing members.
Portfolio auction: After that step, DigitalAssetClear could split the remainder of the defaulter’s portfolio into auction portfolios. An auction is then conducted for each portfolio with members who are major participants in the respective markets.
Bidding - or delegated bidding - in the auction is mandatory for surviving Clearing Members, with non or bad-bidder’s juniorised in the default waterfall.
Loss attribution: In the event that losses are greater than the financial resources of the defaulting member and of LCH, the funded default fund contributions of solvent DigitalAssetClear members are used.
DigitalAssetClear default waterfall
DigitalAssetClear’s default waterfall establishes the order in which the financial resources of a defaulted Clearing Member, solvent Clearing Members and the resources of LCH itself are consumed during a default resolution.
A defaulting Clearing Member’s posted collateral is the first asset to be consumed in managing the default, followed by the defaulter’s contribution to default funds.
If these assets prove insufficient to settle the default, LCH’s own capital is next in line for losses. It is only after all of these resources are exhausted that default fund contributions from non-defaulting Clearing Members are used to cover losses of the close out of the portfolio.
In the extreme event that all waterfall resources are consumed and defaulted positions have not been fully auctioned, we will enter a service continuation phase and potentially a service closure phase.
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