1. What is Default Management?

When a clearing member cannot pay variation margin or settlement amount, CCP declares default and must:

1. Isolate defaulting member's portfolio
2. Hedge risk
3. Auction / liquidate portfolio
4. Allocate losses via Default Waterfall

SEBI Definition India:

Default Handling Process: In case of default by a CCP, in interoperable arrangement, collateral provided by such CCP shall be utilized by non-defaulting CCP to cover losses arising from such default, as per default waterfall prescribed vide SEBI Circular CIR/MRD/DRMNP/25/2014 dated August 27, 2014 on Core Settlement Guarantee Fund, Default Waterfall and Stress Test

This circular is binding on NSE Clearing Ltd, BSE Clearing, MCX Clearing, CCIL, ICCL.

2. The Default Waterfall - 7 Layers (EMIR Art 45 + SEBI + PFMI)

EMIR Art 45 - Law:

A CCP shall use the margins posted by a defaulting clearing member prior to other financial resources in covering losses

Where margins posted by defaulting clearing member are not sufficient to cover losses, CCP shall use default fund contribution of defaulting member to cover those

Full Waterfall as per EMIR + SEBI:

EMIR details rules a CCP shall apply in case of clearing member defaults:

1. margins posted by defaulting clearing member
2. default fund contribution of defaulting member
3. CCP's dedicated own resources
4. default fund contributions of nondefaulting clearing members

Expanded with India practice:

Layer 1 - Defaulting Member's Initial Margin + Variation Margin: 100% of defaulter's collateral used first.

Layer 2 - Defaulting Member's Default Fund Contribution (DF): His share in Core Settlement Guarantee Fund (SGF).

Layer 3 - CCP Skin-in-the-Game (SITG): LCH.Clearnet's rule:

LCH.Clearnet's rules provide that any losses incurred when managing default that have not been absorbed by defaulter's own resources (margin and default fund contributions) should be allocated to CCP's shareholders ahead of default waterfall as prescribed under EMIR

Typically 25% of CCP's minimum capital. For NCL India = Rs 100 cr.

Layer 4 - Non-Defaulting Members' Default Fund: Mutualized loss. Pro-rata.

Layer 5 - Further Assessment Rights: CCP can call additional contribution from non-defaulters up to 1x or 2x their DF (in India, limited to Rs 100 cr per call).

Layer 6 - CCP Remaining Equity: Shareholder capital.

Layer 7 - Resolution / Tear-up: Last resort - partial tear-up of contracts, variation margin gains haircut (VMGH).

Important Distinction:

loss allocation arrangements set out in CCP rulebook typically apply to default losses, contribution of CCP participants through initial margin or default fund could not be called upon in case of nondefault loss

If loss is due to CCP's own investment failure (non-default loss), waterfall cannot be used - CCP shareholders bear.

3. Default Management Process - 5 Steps

Step 1 - Declaration: CCP declares member default after failure to pay margin by deadline (usually T+1 10:30am in India).

Step 2 - Hedging: CCP hedges market risk of defaulter portfolio to stop loss increasing. Uses own traders.

Step 3 - Porting: Client positions of defaulter (if client is not defaulter) must be ported to another clearing member within 24 hours under SEBI Client Protection.

Step 4 - Auction: Defaulter portfolio auctioned to non-defaulting members. LCH uses Dutch auction. If auction fails, CCP allocates proportionally.

Step 5 - Loss Allocation via Waterfall.

4. Case Laws - Where Waterfall Was Tested

A. Global Cases - Most Cited in Exams

1. HanMag Securities vs Korea Exchange (KRX) CCP - 2013 - $39.6M Loss in 2 Minutes

HanMag Securities lost approximately $39.6 million (46.2 billion South Korean won) in less than two minutes and was unable to settle with KRX CCP... Under article 394 of South Korea's Capital Act, KRX was liable for loss only after default loss equivalent to $190 million, so HanMag default loss went directly into clearing member mutualized portion of KRX default waterfall

HanMag, small futures broker, mis-hedged KOSPI 200 options. Algorithm sold 42,000 contracts in error.

KRX declared default, used HanMag margin ($9M) + HanMag DF ($4M) + then mutualized $26M from all other members. Other members sued KRX arguing KRX should pay from own capital first (skin-in-game).

Court held KRX rulebook valid - skin-in-game only after defaulter DF. Mutualization allowed.

Lesson: Waterfall order matters. If CCP skin-in-game too small, innocent members pay.

2. Nasdaq Clearing AB vs Einar Aas - 2018 - $114M Loss - Power Trader

Norwegian power trader Einar Aas bet on spread between German and Nordic power. Spread moved 17x normal. Nasdaq Clearing declared default, loss $114M.

Waterfall:

• Aas margin $15M
• Aas DF $7M
• Nasdaq SITG $7M
• Non-defaulting members DF $85M (107 members)

Members sued Nasdaq for inadequate margin model. Swedish court upheld CCP.

Led to EMIR 2.2 reform: Increase SITG to 50% and cap mutualization.

3. Lehman Brothers - LCH.Clearnet - 2008 - THE SUCCESS STORY

LCH had $9 trillion interest rate swap portfolio of Lehman. LCH managed default without using any non-defaulter DF.

Process: Hedged $9T in 1 week, auctioned in tranches. Used only Lehman's margin $2B. No loss to others.

Proof that proper default management works.

4. Ronin Capital, IRGiT, Keller - US Cases (ISDA 2021 Review)

Ronin capital was individual clearing member, therefore trades associated with default were only those that belonged to Ronin itself... In cases of default at IRGiT and Keller, waterfall resources in addition to initial margin were drawn upon, whereas at CME, no other resources were needed outside of initial margin... It appears that in all three cases, no additional capital was needed outside of prefunded default waterfall

CME used only defaulter margin, did not need mutualization - shows adequate margining prevents contagion.

B. Indian Case Laws

5. Supreme Court of India - Professional Clearing Members Owe No Statutory Duty To Verify Debit/Credit Positions For Trading Member On Default (2023)

Facts: Trading member defaulted, professional clearing member (PCM) liquidated securities under NCL byelaws. Trading member claimed PCM should have verified positions before liquidation, sought restitution.

had no jurisdiction to direct restitution of liquidated securities, since Section 9(3)(b) of Securities Contracts (Regulation) Act, 1956 expressly bars stock exchange byelaws from prescribing any penalty involving payment of money, power reserved exclusively for SEBI under Section 11B

Held: Once default declared, PCM's duty is to CCP, not to trading member. No statutory duty to verify. Liquidation under CCP rulebook is valid. SC protects waterfall.

6. NSE Clearing Ltd - Default of Anugrah Stock & Broking (2019) - Rs 600 cr

Anugrah defaulted, NCL used its margin + DF + invoked Core SGF Rs 150 cr + further assessment. Clients' securities pledged illegally were not returned - led to SEBI order on client collateral segregation.

Led to SEBI Circular 2020: Client collateral cannot be used for mutualized loss - must be segregated.

5. India CCP Default Management - SEBI Circular 2014 vs 2024

Core Settlement Guarantee Fund (CSGF) Structure India:

• NCL (NSE): Rs 7,000 cr - 50% own, 25% member DF, 25% penalties
• ICCL (BSE): Rs 500 cr
• CCIL (Bonds, FX): Rs 2,500 cr

Interoperability Default Handling: Since 2019, India has interoperability between CCPs.

In case of default by CCP in interoperable arrangement, collateral provided by such CCP shall be utilized by non-defaulting CCP to cover losses as per default waterfall

Example: If BSE Clearing defaults to NSE Clearing, BSE's collateral with NSE used first.

6. Best Practice Checklist - For Clearing Member

1. Margin Adequacy: Maintain 1.5x SPAN + Exposure
2. Default Fund Monitoring: Track CSGF utilization ratio - if >30% used, exit
3. Porting Arrangement: Have backup PCM agreement for client porting within 24h
4. Legal Opinion: Ensure your client agreement states CCP rulebook overrides - as per SC judgment, you cannot claim restitution after liquidation.