Case 078Counterparty risk and CVACore

A clearing member defaults with a Rs 300 crore loss on its positions. Run the clearing house's default waterfall and show who pays what.

The situation

Dhruvel Securities, a clearing member of a derivatives clearing house, fails after a violent market move. Closing out its positions leaves a loss of Rs 300 crore. Dhruvel had posted Rs 150 crore of initial margin and contributed Rs 40 crore to the clearing house's default fund.

The clearing house's rulebook puts Rs 20 crore of its own capital next in line, then the default fund contributions of the surviving members, which total Rs 500 crore. Your bank is one of the survivors, with Rs 50 crore in the default fund.

Your task

Run the waterfall layer by layer. How much do the survivors lose, and what does your bank pay?

Quick check

How much of the Rs 300 crore loss lands on the surviving members?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The surviving members lose Rs 90 crore, 18% of their default fund, and your bank pays Rs 9 crore. The loss runs down a fixed order: Dhruvel's Rs 150 crore of margin, its Rs 40 crore fund share, Rs 20 crore of the clearing house's capital, and only then the survivors' pooled Rs 500 crore. Members pay for a default they did not cause, which is the price of a clearing house that never fails its winners.

Step 1Why is there a waterfall at all?

A clearing house stands between every buyer and seller, so when one member fails, the clearing house still owes its winners in full. A cooperative housing society works the same way: if one flat stops paying maintenance, the lift still has to be serviced, first out of that owner's deposit, then out of the society's reserve, and finally by a special levy on everyone else. The default waterfallThe fixed order in which a clearing house uses resources to cover a failed member: the defaulter first, then its own capital, then the other members. spends the defaulter's money first, then a slice of the clearing house's own, and only then the survivors'.

Step 2How does the Rs 300 crore run down the layers?

Fill each layer before touching the next. Dhruvel's Rs 150 crore of margin and Rs 40 crore of fund contribution absorb Rs 190 crore, the clearing house's Rs 20 crore takes the total to Rs 210 crore, and the last Rs 90 crore comes out of the survivors' Rs 500 crore fund. The clearing house's slice is called skin in the gameCapital the clearing house puts at risk ahead of the survivors, so it bears a loss if its own margin models were wrong.; it is small on purpose, a signal of the clearing house's own stake rather than a buffer.

A Rs 300 crore loss filled layer by layer, in order1 Defaulter's initial marginpaid by the defaulter150 of 150cumulative 1502 Defaulter's default fund sharepaid by the defaulter40 of 40cumulative 1903 Clearing house's own capitalpaid by the clearing house20 of 20cumulative 2104 Survivors' default fundpaid by members who did nothing wrong90 of 500cumulative 300Loss 300 = 150 + 40 + 20 + 90; survivors lose 18% of their fund
The Rs 300 crore loss uses all of Dhruvel's Rs 150 crore of margin, its Rs 40 crore fund share and Rs 20 crore of the clearing house's capital, and the last Rs 90 crore, 18% of the survivors' fund, falls on members who did not default.
LayerAvailable, Rs croreUsedLoss left after
Defaulter's initial margin150150150
Defaulter's default fund share4040110
Clearing house's own capital202090
Survivors' default fund500900
Rs 300 crore of loss is gone after four layers: the defaulter's Rs 190 crore, the clearing house's Rs 20 crore, and Rs 90 crore of the survivors' fund, which is used pro rata to contributions.
Step 3What does your bank pay, and what happens next?

Survivors share the fund loss in proportion to their contributions. Your bank put in Rs 50 crore, 10% of the survivors' fund, so it loses 10% of Rs 90 crore, Rs 9 crore, for a default it had no part in. Most rulebooks then require members to top the fund back up, and allow further cash calls on survivors if a loss runs through the whole fund, often capped at a multiple of each contribution. Confirm the exact rule for the clearing house in question.

Finish with what a risk manager takes from it. Your exposure to a clearing house is not only margin you post: it is your default fund contribution, the possible cash call on top, and the chance that two members fail in the same crisis. Banks hold capital against their default fund contributions for exactly this reason, and a counterparty risk team monitors which members are weakest.

Where candidates lose it

The usual slip is to spread the Rs 300 crore across everyone at once, or to put the clearing house's capital first. The order is the rule: the defaulter's own resources go first so that the member who took the risk pays for it before anyone else does.

The second is answering that survivors lose nothing because margin covers losses. Initial margin is sized for normal large moves, not the extreme move that breaks a member; the default fund exists because margin alone will sometimes fall short.

What the interviewer asks next

  • The loss is Rs 800 crore. What happens once the survivors' fund runs out?
  • Why is the clearing house's own contribution kept small?
  • Two members default together. How does a clearing house size its default fund for that?

Company names and figures are illustrative.