Default management is the framework a financial market infrastructure follows when one of its participants defaults, meaning it fails, or is likely to fail, to meet its obligations to the infrastructure. The framework covers how a default is declared, how the defaulter's positions are neutralised or closed out, how client positions are protected, which resources are used to cover losses and in what order, and how the system returns to normal. It is most developed at central counterparties, but payment systems and securities settlement systems have their own versions.
Good default management is what allows an FMI to keep its promises to surviving participants when a large member fails. Principle 13 of the Principles for Financial Market Infrastructures requires every FMI to have effective and clearly defined rules and procedures for managing a participant default, designed so that the FMI can take timely action to contain losses and liquidity pressures and continue meeting its obligations.
Default management in plain terms
A fire drill is the closest everyday comparison. Nobody expects the building to catch fire, but everyone knows where the exits are, who calls the fire service, and who checks each floor. When the alarm goes off, people follow the plan rather than inventing one in a panic.
Default management is the fire drill for a clearing house or payment system. When a bank or broker cannot pay, the system already knows who decides that a default has happened, how the failed firm's positions are sold or handed to others, who pays for any shortfall, and how everyone else keeps trading.
Steps in a CCP default
- Declaration. The CCP determines, under its rulebook, that a clearing member is in default, for example after a missed margin call or the opening of insolvency proceedings, and notifies members and regulators.
- Risk neutralisation. The CCP hedges the defaulter's portfolio to stop losses growing while it prepares to close it out.
- Client porting. Where possible, positions and collateral of the defaulter's clients are transferred to other clearing members, protected by collateral segregation.
- Close-out. The CCP sells or auctions the house portfolio, usually to surviving members, in packages that bidders can price.
- Loss allocation. Losses are covered by the defaulter's initial margin and default fund contribution, then the CCP's own capital, then the mutualised clearing fund and any further assessments, in the order set by the rules.
- Replenishment. Members restore the default fund and the CCP returns to normal operation.
CCPs usually rely on a default management group of traders seconded from member firms to advise on hedging and auction design.
Default management in payment systems
In a deferred net settlement system, the immediate problem is that a net debtor cannot pay its settlement obligation. Older systems handled this by unwinding the defaulter's payments and recalculating everyone's positions, which could spread losses unpredictably. Modern systems instead use collateral pools, loss-sharing agreements and committed liquidity so that settlement completes on time even if the participant with the largest obligation fails. In real-time gross settlement systems, exposure between participants is small, and default procedures focus on removing the defaulter's queued payments and dealing with any intraday credit extended by the central bank.
Testing and transparency
The PFMI expect FMIs to involve participants in testing and reviewing their default procedures at least annually and after material changes. CCPs run "fire drills" in which members practise bidding in simulated auctions. FMIs must also publish key aspects of their default rules, so participants can judge the risks they bear, including their potential exposure to mutualised losses.
Real-world cases
When Lehman Brothers failed in September 2008, LCH managed the close-out of Lehman's large interest rate swap portfolio through hedging and auctions among members, and the losses were absorbed within the margin Lehman had posted. In 2018, the default of an individual trader in Nordic power futures at Nasdaq Clearing went beyond his margin and required use of the mutualised default fund, prompting debate about CCP risk models, auctions and the size of CCP skin in the game.
Limits and recovery
Default management handles the default of one or a few members within prefunded resources. If losses exceed those resources, a CCP enters recovery, using tools such as cash calls, variation margin gains haircutting or contract tear-ups, and ultimately resolution under public authorities. International guidance on CCP recovery and resolution has grown since the 2008 crisis, reflecting concern that CCPs have become concentrations of systemic risk following the move to mandatory clearing of many OTC derivatives.