Margins and the safety of clearing houses

Abstract

The major distinguishing feature of a futures market is the system of margining. In providing a guarantee, the clearing house bears the risk that price changes will exceed the initial margin, (a market risk), and that members will be unable to pay, (a credit risk). By bad judgement or management it is possible for clearing houses to fail, as happened in Hong Kong in 1987. This paper examines the capital required by clearing houses, using the International Commodities Clearing House in London as an example. Given the level of margining in 1987, it is found that exposure might exceed £40 million about once per year and £200 million once per thirty years. ICCH needs credit lines to cover these levels of exposure, plus enough capital to cover the proportion of these that are defaulted. These capital requirements are much smaller than they would be if only one market were being margined — there is a large diversification gain from clearing many futures markets. How the capital should be obtained — through shareholders' equity, by forming a mutual association, or by purchasing insurance — is discussed.