Strengthening Defaulter Pays

In March 2023, the London Metal Exchange (LME) and LME Clear announced a two-year action plan to enhance and strengthen their markets. This included implementing measures to ensure confidence in the resilience of LME Clear and its members, by both reducing the risk of default and changing the way LME Clear manages the risk of a member going into default.

Since the action plan was announced we have carried out extensive reviews of LME Clear’s core margining and default resources and engaged with our members to ensure the overall resources available to LME Clear are optimised and continue to be aligned with the level of risk it manages.

One of the key aims of the work has been to ensure that the proportion of mutualised risk that is paid through members’ Default Fund contributions is relative to the risk they bring to the overall system, further strengthening our “defaulter pays” model. Put simply, this means ensuring that members who bring the largest market risks have the appropriate creditworthiness, liquidity and financial resources for those risks.

LME Clear’s Waterfall 

In common with other clearing houses, LME Clear uses a “waterfall” model to manage the impact and costs of a default. The waterfall sets out the order in which the financial resources of a defaulting member, other members’ resources and LME Clear resources would be used.

In the LME Clear approach, the first resources used would be those of the defaulting member – the collateral collected through margins from the member that reflect the riskiness of its cleared activity. Next to be used would be that member’s contributions to the central Default Fund, to which all members contribute, followed by “skin-in-the-game” resources from LME Clear. Should those be exhausted, then the next pool to be used would be other members’ contributions to the Default Fund and ultimately Default Fund replenishments and other recovery tools¹.

Initial (and other forms of) margin can’t cover all of the risks, so members face the mutualised risk of sharing the burden of the costs arising from the failure of another member. The recent changes provide further certainty over the total losses any one member could have to LME Clear’s Default Fund and, by extension, more clarity for clearing members about their potential share of the overall cost.

Through the action plan we have introduced a number of changes to different elements of the waterfall to strengthen resilience and the “defaulter pays” model, helping members to more clearly quantify their potential loss even in extreme market conditions.

Initial Margin 

Clearing members post Initial Margin for each position they hold (and potentially concentration additional margin (CAM) for larger positions) to cover any losses should they default. The Initial Margin is calculated to be sufficient to offset potential future losses that are incurred between the time of a default and the closing out of the position.

LME Clear calculates Initial Margin based on price scanning ranges – an assessment of how much a contract’s price could vary over an assumed two-day liquidation period. We reviewed some of the elements that make up the calculations for the price-scanning range for six of the LME’s main contracts. This resulted in a number of recent changes such as a more frequent review of the levels of Initial Margin, with the price scanning range now calculated as a relative figure (ie a percentage) rather than as an absolute figure (ie USD). These, together with other technical improvements we have made to the price scanning range calculations, should lead to a more conservative and consistent model for Initial Margin that reflects prevailing market conditions and a member’s business activity.

Stress Loss Additional Margin (SLAM) 

Another innovation in the recent changes has been our introduction of the Stress Loss Additional Margin (SLAM). This is a credit assessment-based limit for uncovered stress testing losses that applies to all clearing members, irrespective of the internal credit rating. LME Clear stress tests each member’s portfolio at the end of every day using a broad range of extreme but plausible scenarios. Their largest hypothetical stress testing loss is then compared to the stress loss exposure threshold.

Should a member exceed their limit, they will need to cover the excess with additional non-mutualised margin. This provides an additional layer of the defaulter’s own resources that can be used by LME Clear in the event of a default. Crucially, this is before other members’ contributions to the Default Fund are used, moving mutualised funds further away from any potential default losses.

By linking SLAM to the credit risk for that member, the additional margin is closely tied to the member’s business and their associated risk profile; another element of “defaulter pays”. This also has the advantage of creating a known loss per credit rating that other clearing members can use to assess what loss they might incur, even in the event of a default in stressed conditions.

Mutualisation Limit 

Perhaps the most significant change resulting from the action plan is the introduction of a new mutualisation limit for the Default Fund.

In common with many CCPs, the size of LME Clear’s Default Fund is based on assessing the potential losses arising from the failure of the two largest clearing members under a range of extreme but plausible scenarios. The size is derived from results from the previous three months plus an additional buffer of 10% to allow for fluctuations between monthly Default Fund resets.

Previously, during times of extreme market volatility and rising prices, there was the potential for outsized stress losses from a small number of members to result in a significant rise to the Default Fund and therefore for all members to be required to make additional contributions.

In August 2023, we set out a new methodology for the minimum size for the Default Fund, to be 10% of the average size of the total Initial Margin over the previous six months. We have now introduced a mutualisation limit for the Default Fund, which is 14% of the average size of the total Initial Margin over the previous six months.

With the introduction of an anti-procyclicality control, which limits the amount the Default Fund can drop in any given month to 10%, these changes increase stability and predictability for the Default Fund, and for the contributions from members.

Defaulter Pays 

Taken together, these changes mean that LME Clear’s approach for default management aligns the resources provided by clearing members far more closely with their business and provides clear economic incentives to manage their risks. The changes place limits on the size of each individual member’s uncovered stress losses relative to their creditworthiness, and the size of the Default Fund. Stress losses above the member’s limit will lead to additional margin for the member rather than an increase in mutualised funds for all clearing members.

Not only has this strengthened the principle that the “defaulter pays”; it has also given LME Clear members greater clarity about their potential exposure in the event of a default. The benefits of our new approach are visible to all.

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¹ _{Details of recovery tools available can be found in the LME Clear Rulebook}