Overview of Default Management Fire Drill

Presentation at CFTC Market Risk Advisory Committee Meeting

April 2nd, 2015
2

Scope

 A fire drill is a test for the end-to-end coordination of the default management process.

 Each Clearing Service must conduct regular fire drills to test the procedures and processes 

in place to manage a member default.

 In addition, LCH.Clearnet runs a Group-wide fire drill exercise at least once per year that 

assumes the default of a member that has exposure across all Clearing Services in all LCH 

CCPs. It covers areas such as:

• Gathering of default management group for each Clearing Service

• Simulation of liquidation strategy, hedging strategy, close out auctions

• Client porting

• (LCH.Clearnet Limited Only) Non-default loss process for managing a loss arising from treasury 

activities resulting from the default of a non-clearing member or sovereign default
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Design

 The fire drill is designed so that the steps taken in the default management match, to the 

extent practicable, those that would be taken in the event of a real default. Some of the 

decisions that need to be made include:

Timeline

- The entire timeline from pre-default, 

declaration of default, default 

management to closeout

Default exposures

- Services that are impacted

- Exposure sizes

- Types of client accounts (e.g., 

LSOC)

- Other interdependent relationships 

(e.g., investment counterpart of one 

of the CCPs)

Default fund waterfall

- The stages of the default fund 

waterfall that will be tested (e.g., 

assessment, VM haircut, service 

closure)

Other considerations

- Operational processes that can be 

tested in real systems vs. those that 

need to be simulated

- Extent of external clearing 

members’ involvement
4

Planning

 Group Risk is responsible for the overall planning, design, general coordination, and 

evaluation of the fire drill. 

 Regulators are invited to observe the fire drills. The most recent LCH fire drill was attended 

by CFTC, Bank of England, AMF, ACPR, and the Banque de France.

 Functional lines involved in the fire drill includes:

 Each group is responsible for having a set of up-to-date Default Management Procedures 

that details the step-by-step processes it will take to managing a default.

Default 

Management Group 

(DMG) in each 

Clearing Service

Risk Legal Compliance Finance

Collateral and 

Liquidity 

Management

Collateral 

Operations

Communications, 

etc.
5

Execution

 Typical activities during a fire drill are as follows:

Identification and 

activation/Analysis of 

situation

•Internal update on 

potential default of the 

hypothetical member

•Preparation for a 

default

Declaration of default

•Internal decision to put 

the hypothetical 

member in default

•Internal and external 

communications to all 

relevant parties

•Update of risk, 

collateral, and liquidity 

of house and client 

positions

Stabilization and 

close out preparation

•DMG meet to 

determine hedging, 

client porting, and 

liquidation strategies

•Execute hedges

•Daily and intraday 

updates of risk, 

collateral, and 

liquidation positions

Liquidation/auction/ 

porting

•Execute liquidation, 

auction/client porting 

strategies

•Daily and intraday 

updates of risk, 

collateral, and 

liquidation positions

Assessment of default 

fund waterfall (assume 

prior layers of 

resources are used)

•Test procedures for 

calling unfunded 

assessments and VM 

haircutting
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Evaluation

 A formal report is produced to summarize findings from the fire drill exercise. 

 The report is presented to each CCP’s management committee and also the Group Audit 

Committee

 The report includes the following:

 The success of the fire drill is evaluated based on how well default management procedures 

are executed and implemented by the business and functional lines.

Key areas requiring focus and 

further development

Recommended actions and 

completion dates

Considerations for the next fire drill
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Appendices
8

Default Management Principles

Maintain ongoing 

performance of 

LCH.Clearnet obligations 

vis-à-vis all other nondefaulting clearing members

• LCH.Clearnet continues to 

meet its obligations, including 

those of the defaulter, such 

as meeting payment and 

delivery obligations (if any)

Preserve LCH.Clearnet 

capital and default fund(s)

• LCH.Clearnet will seek to 

preserve the LCH “Skin-inthe-Game” capital and 

mutualized resources 

contributed by non- defaulting 

members to the default 

fund(s)

Manage the transfer of all 

segregated client positions 

• LCH.Clearnet will seek to 

facilitate the transfer of the 

defaulting member’s client 

positions and segregated 

collateral to other clearing 

members
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Default Management Group (DMG)

• DMGs are convened within the first few hours of the Default Notice being served and are responsible for 

the day-to-day management of the default process. 

• Members of the DMG may include seconded trading representatives from clearing members in advisory 

roles. 

• Example of activities conducted by a DMG: 

Determine the defaulting member’s 

assets and liabilities and LCH’s risk and 

liquidity exposures

Determine the hedging strategy to 

neutralize material market risks 

associated with the defaulter’s position 

Determine the client porting strategy

Determine the wind down strategy (hold 

auction and/or liquidate the remaining 

positions) 

Default 

Management Group
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Default Management Phases

Identification 

and activation

Analysis of 

situation

Declaration 

of default

Stabilisation

and close out 

Preparation

Liquidation 

and/or 

transfer

Operational & 

financial 

reconciliation

Closing

1 2 3 4 5

Objective

Based on day to 

day operations, 

identify unusual 

events and 

escalate to the 

crisis 

management 

team for a 

potential 

activation of the 

default 

procedure

Objective

Collect all 

required 

information 

to assess the 

situation and be 

able to declare a 

default

Objective

Make decision 

and 

communicate to 

the defaulting 

member and all 

appropriate third 

parties (including 

regulators)

Objective

Prevent the 

defaulting 

clearing member 

and all its 

clients/TMF from 

any trading and 

clearing actions

Extract final file 

of positions to 

be transferred/ 

liquidated

Objective

Choose scenario 

and perform 

appropriate

transfers to a 

new CMF and/or 

liquidation with 

brokers or direct 

offer counterparts

Objective

Reconcile 

settlements and 

calculate 

financial 

impacts of the 

default for the 

member, the 

clearing fund and 

the clearing 

house

Objective

Close last open 

issues, terminate 

agreement with 

the defaulting 

member and 

make a final 

report

Pre-default Post-default

TMF – Trading Member Firm

CMF – Clearing Member Firm
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Non-Default Loss Fire Drill

 Non-default loss refers to the loss arising from treasury activities that is incurred as a result of a nonclearing member default or sovereign default.

 Examples of non-default loss include: 

• Unsecured deposit loss as a result of the default of the depository institution;

• Secured reverse repo loss as a result of the default of a reverse repo counterparty

• Sovereign loss as a result of the default of a sovereign in which treasury has securities exposures

• In LCH.Clearnet Limited, non-default loss is allocated to members after the CCP absorbs the first 

EUR15mm of losses.

 Functional lines involved in the non-default loss fire drill includes:

 After the completion of the fire drill, a log of all areas that requiring further attention is produced. Owners 

and targets dates are assigned to each action to ensure the issues are resolved and embedded in the 

future.

Risk Legal Compliance Finance

Collateral and 

Liquidity 

Management

Collateral 

Operations Communications
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The contents of this document have been provided to you for informational purposes only and are intended as a broad overview of certain 

aspects of the SwapClear Global Service and the SwapClear US-Domiciled Service, services of LCH.Clearnet Limited and LCH.Clearnet

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