What is risk at an FMIs?
FMI risk is different from bilateral credit exposure and is typically a lower risk. This said, due to the existence of a default fund, liquidity funds and loss-sharing arrangements, counterparties can incur credit-like losses, even in the absence of the default of the counterparty itself. Central Counterparties (CCPs) most frequently exhibit these risks
Exposure can also be varied, and institutions may function as members of an FMI as well as direct lenders or a repo counterparty. This creates unusual dynamics in terms of risk analysis at FMIs.
FMIs typically place the highest risk on funded default funds (or their equivalents), as these represent the most likely layer of exposure to be used. In extreme circumstances, CCPs expect to draw on these default funds—and recent events have shown this in practice.
In a ‘normal’ FMI member default scenario, it is unlikely any bilateral exposure would be affected, but at the point, a member default leads to an FMI default, these exposures could also be subject to loss. Users can take actions, such as the utilisation of bankruptcy remote IM, to lower their exposure in the case of an FMI default.
Areas to consider when designing a risk framework
There are many considerations and specifics when designing a framework. Any framework should contain an assessment of the following aspects. These varied factors tend to be more or less important at different types of FMIs. For example, liquidity risk can be a particular issue for payments, whereas default management processes are primarily a CCP issue.
Member Risk
One of the core questions to consider is who else is a member of the FMI. If the entry requirements are too low, this is a key source of risk. Members with limited liquidity and small balance sheets are less likely to be able to cope with volatility, and as such, increase the risk of losses at the FMI. CCP interoperability can be grouped in member risk, as CCPs may be linked, potentially allowing contagion. Key considerations are the capital and liquidity requirements to onboard and how the CCP has mitigated ‘riskier’ members (for example, via add-ons, limits etc.).
Margin Risk
Another fundamental question is, does the margin model work adequately? At the most basic level, one can assess the confidence level of the margin model but overall, assessing the adequacy is one of the more challenging aspects, especially at portfolio level at a CCP. For individual products or payments, it is easier, and individual product margins can be assessed for their sufficiency. For portfolios, this may require usage of margin calculators or working with FMIs to provide more granular information. CCP quantitative disclosures can also provide details on backtesting breaches, which also highlights whether a margin model is working ‘in-sample’ to a specified level of confidence. There has also been a trend to ‘defaulter pay,’ meaning that the sufficiency of these models is fundamental to avoiding mutualised losses.
Margin Add-ons
Not all risks can be captured adequately in the initial margin models, and members should also focus on issues not adequately captured. For example, concentration risk is one of the major add-ons needed to CCP models, as typically a core-IM model cannot calculate if a participant has a very concentrated position in a product/portfolio. This concentration could increase the expected loss and the add-ons in place are an essential part of the review of an FMI. Even payment systems need to consider becoming over-exposed to a given member.
Liquidity Risk
Credit issues can quickly spiral into liquidity problems, and so the question to ask is whether the FMI has cash available in the right currency and in the right place. For example, offering products in USD might help attract international investors in a non-USD country but how is the FMI able to fund a large payment in USD without sufficient reserves (if a member failed to pay). Operational considerations also arise, as restrictions may limit how and when you can move or liquidate cash and collateral. One of the biggest protections an FMI can have for liquidity risk is access to central bank facilities.
Default Management Risk
Primarily a CCP risk. You must understand how defaults are managed and what your obligations are. In CCPs, poorly designed default processes can amplify risk, push prices beyond modelled boundaries, and increase the chances that your default fund contribution will be used. Certain CCPs may also push more exposures into the default fund, potentially increasing the risk at a given CCP. You should assess how segmented the default fund is, since poorly contained segmentation can allow losses to spread across asset classes. Therefore, scrutinising the default fund process is essential alongside understanding your specific obligations in the default of another member.
Operational Risk
A big focus over recent years has been operational resilience and risk at FMIs, and there have been high-profile incidents over the last few years. As a member, you will not be able to fully analyse this, but it is important to scrutinise any operational or cyber policies and where possible, track the operational incidents at FMIs to try and ascertain a weakening trend. Bringing in experts is also important in this area of risk assessment.
Legal Risk
The key here is to try and get as much legal certainty as possible before joining an FMI. Understand what work the FMI has done to ensure the enforceability of its rule book and its ability to use collateral. A legal challenge to the enforcement of the rules would create severe challenges for an FMI to continue to operate in a crisis, so gaining an understanding of how the FMI has assessed these risks is essential. This is also a critical area to validate the exact obligations you have to the FMI (e.g., number of assessments, juniorisation etc.).
How to bring this all together?
We believe a scoped, scorecard-based approach best suits FMI risk, given the limitations of historical data on FMI defaults. There are several papers on CCP quantitative approaches especially for US banks subject to CCAR, but given the slightly unusual nature of FMIs, we still believe scorecards are the best way to measure the overall risk of an FMI. Certain criteria will not be applicable for certain FMIs, and so ensuring the scorecards are adjustable to a particular type of FMI is also important.
You can link scorecards to traditional credit ratings to help the organisation better understand FMI risk. A slightly more advanced approach would be to analyse the risk of funded default funds distinctly from the actual FMI (as this would have a lower credit risk rating).
It is also important for organisations to take a multi-disciplinary approach to FMI risk. There should be a core team, but this team should have the ability to draw on quants, operational risk, credit, legal and traders to best understand the risks posed. Governance forums enable participants to share information and hold FMIs more effectively to account.
Risk assessments should be subject to annual updates and whenever there are fundamental changes to the rules or the introduction of new products and services. The FMI impact review should also embedded in the new product approval process. You should assess FMI risk both holistically and at the legal entity level to understand overall exposure and potential impacts on each entity—such as whether its capital could cover losses, even if the broader group remains solvent.
How can Davies help?
As experts in clearing, risk and regulation, we can assist in all areas of FMI Risk assessment including, but not limited to, data collection & analysis, FMI risk assessments and governance. We have practical experience in managing risk at FMIs during the recent market volatility in energy and metals markets.
To find out more about how we can assist you with any aspect of the points raised above, or your wider requirements, please contact us.
