Clearing Fund

A clearing fund is a mutualised pool of financial resources that the members of a clearing house or central counterparty (CCP) are required to contribute. If a member defaults and the losses from closing out its positions exceed the initial margin and other collateral it posted, the clearing house can use the fund to absorb the remainder. "Clearing fund" is the name used by several US clearing agencies; elsewhere the same thing is usually called a default fund or guarantee fund.

The clearing fund is one layer in the default waterfall, the order in which resources are used to cover a member's failure. It sits behind the defaulter's own margin and contribution, and is shared among surviving members, which is what makes it mutual. Because the fund spreads losses across members, its size, the formula for each member's share, and the rules for using and replenishing it are among the most closely watched features of a CCP.

Picture a group of builders who share a crane. Each builder pays a deposit sized to the jobs they do, and also chips into a common emergency pot. If one builder damages the crane and walks away, the builder's own deposit is used first. If that is not enough, the common pot pays the rest.

The clearing fund is that emergency pot. Every member pays in, the money sits there in case someone fails, and if it is ever dipped into, the remaining members may have to top it up. That shared stake gives every member a reason to care about how carefully the clearing house manages risk.

CCPs size their mutualised resources by stress testing. They model extreme but plausible market moves and estimate the loss that would remain if certain members defaulted after their margin was used. Under the Principles for Financial Market Infrastructures, a CCP should hold enough financial resources to cover the default of the participant, together with its affiliates, that would cause the largest credit exposure in such conditions, known as cover 1. A CCP that is systemically important in more than one jurisdiction, or that clears complex products, should cover the two largest, known as cover 2.

Each member's share of the fund is usually calculated from its risk, for example in proportion to its margin requirements or stress exposures, subject to a minimum. Contributions are typically held in cash or high-quality securities and recalculated on a regular schedule.

A typical waterfall applies resources in this order:

1. The defaulting member's margin, including initial margin and any unpaid variation margin already collected.
2. The defaulting member's own clearing fund contribution.
3. A tranche of the CCP's own capital, often called skin in the game.
4. The clearing fund contributions of non-defaulting members.
5. Further assessments or calls on surviving members, up to a cap set in the rules.
6. Any remaining CCP capital and recovery tools.

The exact order and size of each layer differ between clearing houses and are set out in their rulebooks. The clearing fund is used only through the CCP's default management process, after it has tried to close out or auction the defaulter's portfolio.

In the United States, the National Securities Clearing Corporation and the Fixed Income Clearing Corporation, both part of DTCC, call their mutualised resources clearing funds, as does the Options Clearing Corporation. Derivatives CCPs in Europe and Asia generally use "default fund". The function is the same: a buffer that lets the CCP keep its promise to perform on cleared trades even if a clearing member fails.

For a member, the clearing fund contribution is both a cost and an exposure. It ties up capital and liquidity, and members can lose it through no fault of their own. Bank capital rules under Basel III therefore apply a specific charge to default fund contributions to qualifying CCPs, reflecting this mutualised counterparty risk.

Members tend to argue for larger CCP skin in the game and tight limits on assessments, so that losses from a CCP's own risk decisions do not fall mainly on them. CCPs reply that mutualisation is central to clearing and that members are best placed to monitor each other. Regulators have pushed for more transparency, including public quantitative disclosures, so that members can judge the adequacy of the fund and the systemic risk it is meant to contain.

• Principles for Financial Market Infrastructures (CPMI-IOSCO)