When CH (clearinghouse) member fails to meet its financial obligation.. doubt

[Shazam023]

okay so what i have been reading here that when a Ch member fails to meet its financial obligations his fully margined positions are transferred and under-margined positions are liquidated.

i'm confused about who is Ch member here and whose customer a/c is this??
if a customer fails to meet its margin call what happens to a broker?? which member's exchange membership is sold to meet the deficit??

i hv just started Book 3 so kind of new to these terminology about member/customer/broker.

 

[Deepak Chitnis]

Hi @Shazam023, Every clearing house has members, like customers needs to maintain a margin account with broker, every member need to maintain margin account with clearing house. As same every broker needs to maintain the margin account with clearing house member. When there are liquidity problems margin account balance is used to fulfill financial obligations. If customer fails to fulfill his margin balance is used, if its still not fulfill the obligation then brokers margin account balance is used, then clearing house members margin account balance is used, if still there is deficit the members membership is soled, if its still failed to fulfill obligations, then surplus fund of the clearing house is used. Then contribution of other clearing house members to the guaranty fund is used. Then finally all clearinghouse members shall be asked with special pro rata to make up any deficiency in guaranty fund. Hope that helps.
Thank you

 

[Shazam023]

Hi @Shazam023, Every clearing house has members, like customers needs to maintain a margin account with broker, every member need to maintain margin account with clearing house. As same every broker needs to maintain the margin account with clearing house member. When there are liquidity problems margin account balance is used to fulfill financial obligations. If customer fails to fulfill his margin balance is used, if its still not fulfill the obligation then brokers margin account balance is used, then clearing house members margin account balance is used, if still there is deficit the members membership is soled, if its still failed to fulfill obligations, then surplus fund of the clearing house is used. Then contribution of other clearing house members to the guaranty fund is used. Then finally all clearinghouse members shall be asked with special pro rata to make up any deficiency in guaranty fund. Hope that helps.
Thank you

thnkx @Deepak Chitnis .. but what happens to a broker when a customer defaults?? why his membership is sold when its customers' fault ??

 

[Deepak Chitnis]

Hi @Shazam023, I dont think I am right person to answer this (because I dont have much experience), but I will try, clearing house is for standardized contracts like future, that means there are less counter party risk or you can say less liquidity risk. If some customer fails to fulfill the financial obligation the membership is sold because the clearing house itself became the buyer who is selling and seller to who is buying, that means clearing house need to pay seller (seller is not dependent on the buyer for money). Clearing house need to pay him if trade is confirmed, if the customer fails to fulfill the financial obligation the clearing house try to do above things. If they did not do so(like selling membership) they are unable to fulfill the obligation and there will arise the liquidity risk, they will be no more standardized contracts(will be like forwards or OTC). Clearinghouse takes each possible step to fulfill the financial obligation. As per my readings, I know this little bit. But you can ask to David for more. Hope that helps.
Thank you

 

[Shazam023]

@David Harper CFA FRM CIPM can you please help with my query in above comments...????

 

[Nicole Seaman]

@Deepak Chitnis

I will let David answer the actual questions, but I awarded you two stars for helping out!

Nicole

 

[Shazam023]

@Deepak Chitnis

I will let David answer the actual questions, but I awarded you two stars for helping out!

Nicole

@Nicole Manley will anyone reply to my query??

 

[Dr. Jayanthi Sankaran]

Hi @Shazam023 ,

Every futures exchange in the US has an affiliation with a clearing house. The primary role of the clearinghouse is to provide the financial mechanisms to guarantee performance on the exchange's futures and options contracts. To accomplish this, the clearing house substitutes itself for each counterparty for the purpose of settling gains and losses, paying out funds to those with profits and collecting from those with losses.

All clearinghouses require clearing member firms to deposit funds known as original margin. Each clearing house member must establish two separate margin accounts at the clearinghouse: one for customer funds and one for its own funds. Margin levels generally reflect the historical volatility of futures prices and are set to protect the clearinghouse against one day's (statistically) large price movements in a particular market.

Each day all clearinghouse member firms either must pay or receive from the clearinghouse the difference between the current settlement price and the trade price. This difference is known as the variation margin. Variation margin is collected separately for customer positions and the clearing member's own positions

Members of a clearing house, in addition to providing the original and variation margin needed to support their own and customer positions, also must maintain a sizable guaranty deposit. This reserve must be freely available to the clearinghouse at all times to be used, if necessary to meet the financial obligations of any defaulting member.

Should an individual customer of a clearinghouse member become unable to fulfill his financial obligation, the obligation must be assumed by the carrying clearinghouse member itself, using its own funds to make up any customer deficit. That is why brokers insist that margin calls be answered promptly and in full and why the broker has the right to liquidate any customer positions, without recourse, in the event margin calls are not met properly.

In the event a clearinghouse member is unable to meet its financial obligations:

• All open and fully margined customer positions on the failed member's books are transferred to a solvent clearinghouse member. Under-margined customer positions and the firm's proprietary positions are liquidated

• If the failed member's margin deposits on hand are not sufficient, his exchange membership may be sold and his contribution to the clearinghouse guaranty fund may be used

Thanks
Jayanthi

 

[Nicole Seaman]

@Shazam023

Yes, David tries to answer every single question in the forum. He has been working very hard in the forum, answering many questions per day. If he has not answered, it may be because (1) he has not made it to your question yet or (2) the other members who have answered, gave you the same answers that he would have given.

Thank you,

Nicole

 

[Shazam023]

@Jayanthi Sankaran
thnkx for this explanation... cleared many doubts i had.
just one more thing.. y broker has to pay when customer defaults? suppose a broker X has 3 clients and ol of thm refuses to pay margin call and lets say the margin call for each client is $5000. so it means X has to pay approx. $15000 from his own a/c?? thn whts the use of being a broker. it looks like A has to pay for the mistakes of B..

 

[David Harper CFA FRM]

Hi Shazam023

Just as @deepak wrote, there are two relationships:

• between an investor (client) and his/her broker, who may or may not be a clearinghouse member; and
• between the member and the clearinghouse

Clearinghouses do not have maintenance margin: their variation margin is settled daily, in full, so this itself seems like a pretty effective safeguard in the sense that the clearinghouse won't go more than a day's worth of credit exposure to members. See https://forum.bionicturtle.com/threads/variation-margin.8847/#post-37043

Just to get a sense, here are CME's member firms http://www.cmegroup.com/tools-information/clearing-firms.html

With respect to defaults or potential default by a clearinghouse member ...

... Here is what Hull says (just to give the summary context for the relationship):

Hull (chapter 2): The Clearing House and Its Members : A clearing house acts as an intermediary in futures transactions. It guarantees the performance of the parties to each transaction. The clearing house has a number of members. Brokers who are not members themselves must channel their business through a member and post margin with the member. The main task of the clearing house is to keep track of all the transactions that take place during a day, so that it can calculate the net position of each of its members. The clearing house member is required to provide initial margin (sometimes referred to as clearing margin) reflecting the total number of contracts that are being cleared. There is no maintenance margin applicable to the clearing house member. Each day the transactions being handled by the clearing house member are settled through the clearing house. If in total the transactions have lost money, the member is required to provide variation margin to the exchange clearing house; if there has been a gain on the transactions, the member receives variation margin from the clearing house. " -- Hull, John C (2014-02-19). Options, Futures, and Other Derivatives (9th Edition) (Page 32). Prentice Hall. Kindle Edition.

... and here is what Chapter 2 of the (2015 assigned) IFM (emphasis mine):

"Guaranty Deposit
Members of a clearinghouse, in addition to providing the original and variation margin needed to support their own and customer positions, also must maintain a sizable guaranty deposit with the clearinghouse. This deposit, which may not be withdrawn as long as the firm remains a member of the clearinghouse, can range from a few thousand dollars to as much as several million dollars, depending upon the clearing organization and the member involved. Generally, the guaranty deposit may be in cash, securities or letters of credit. This reserve must be freely available to the clearinghouse at all times to be used, if necessary, to meet the financial obligations of any defaulting member.

Should an individual customer of a clearinghouse member become unable to fulfill either his financial or delivery obligation, the obligation must be assumed by the carrying clearinghouse member itself, using its own funds to make up any customer deficit. That is why brokers insist that margin calls be answered promptly and in full and why the commodity account agreement of each brokerage house gives the broker the right to liquidate any customer positions, without recourse, in the event margin calls are not met promptly.

In the event a clearinghouse member is unable to meet its financial obligations on its open contracts, as has happened on various occasions throughout history, the following procedure generally is followed:

• All open and fully margined customer positions on the failed member's books are transferred to a solvent clearinghouse member. Under-margined customer positions and the firm's proprietary positions are liquidated.
• If, as a result of this liquidation, the member's customer account with the clearinghouse is in deficit, any remaining margin the member had deposited at the clearinghouse is applied toward the deficit on customer positions.
• If the failed member's margin deposits on hand are not sufficient, his exchange membership may be sold and his contribution to the clearinghouse guaranty fund may be used.
• If the member's account is still in deficit, the surplus fund of the clearinghouse, if any, may then be drawn upon at the discretion of the clearinghouse board.
• If necessary, further recourse can be made to the contributions of other clearinghouse members to the guaranty fund.
• Finally, if necessary, a special assessment can be made against all remaining members of the clearinghouse; that is, the remaining members may be asked, by special pro-rata assessment, to make up any deficiency in the guaranty fund resulting from recourse to the preceding procedure.

The selection criteria of clearinghouse members, the guaranty-fund deposits and the ability of the clearinghouse to assess clearinghouse members to fulfill its obligations buttress the financial integrity of each futures contract. There have been no instances in which the failure of a clearinghouse member has resulted in the failure of a U.S. clearinghouse to meet its financial obligations."

... And finally, here is CME (as an actual example):

"House Account Default: If a Clearing Member fails to meet its financial obligations to CME Clearing, related to its house account (sometimes referred to as proprietary or non-customer) account, CME Clearing may act immediately to:

• Transfer segregated and cleared swap customer account customer positions and collateral to a non-defaulting Clearing Member;
• Take control of and/or liquidate positions in the Clearing Member’s house account;
• Apply the Clearing Member’s Guaranty Fund and house performance bond deposits to satisfy the Clearing Member’s obligations to CME Clearing with regard to its house account;
• Utilize all other assets of the Clearing Member that are available to CME Clearing (e.g., Exchange memberships); and/or
• Invoke any applicable parent guarantee.

Customer segregated and cleared swap customer account assets (positions and/or collateral) on deposit with or in the control of CME Clearing may not be used or impaired by CME Clearing in the case of a Clearing Member default related to the house account."

This last information is from CME Clearing Risk Management and Financial Safeguards, here at https://www.dropbox.com/s/1ub5pdcvn5cp8vb/cme-financialsafeguards.pdf?dl=0