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Mutualised default fund will protect dairy derivative market

NZX says mutualised default fund will better protect dairy derivatives market


By Rebecca Howard

Nov. 9 (BusinessDesk) - NZX says a new mutualised default fund will better protect its dairy derivatives market and allow for further market growth.

NZX Clearing, the central counterparty that settles all NZX on-market transactions, determined its current approach was not sustainable or economically efficient to support the continued growth of the derivatives market. The fund's introduction follows a 12-month consultation and engagement period.

The NZX dairy derivatives market was launched in 2010 to provide risk management tools for anyone with price exposure to the global dairy market. In the year to the end of October, total dairy derivatives lots traded - including futures and options - was 283,484, up from 29,035 lots in the same period in 2013.

The new default fund will require contributions from all dairy derivatives clearing participants and builds on a series of initiatives the NZX has carried out during the past year. These include increasing trading functionality and extending market hours to meet customer demand in Asia and Europe.

"The mutualised default fund is an essential enhancement to NZX's risk management framework and will support the growth of our global derivatives market. Core to the delivery of the fund is efficient utilisation of capital when providing market protection, which in turn supports market growth," said Benjamin Phillips, NZX head of markets development.

Under the previous system, cash or assets available to NZX Clearing (NZC) in the event of a derivatives clearing participant default included collateral provided by the defaulting participant to cover the margin requirement and risk capital of $20 million provided by NZX.

This meant NZX Clearing was providing more than 66 percent of the required capital to meet potential losses arising from a clearing participant’s default.

"Continuation of this structure imposes high and uneconomical costs on NZC to meet the growth of the derivatives market and the associated derivatives clearing participant risk related to these exposures," it said.

Under a default fund structure, rather than the cost of the default being carried by clearing participants individually, the pre-funding obligation for a single default is shared across all clearing participants contributing to the fund.

In addition, the contribution of each clearing participant to the default fund is calculated according to its market share of the risk exposures, the NZX said.

NZX Clearing will determine the default fund size by performing a stress test on the largest derivatives clearing participant’s net derivatives exposures. The total default fund requirement is derived from the highest daily stress losses if that participant were to default under the specified stress scenario.

Derivatives participants who are creating the greatest risk to the market will make the greatest contributions to the default fund.

Based on the assumption of a 75 percent growth in derivatives trading volume, NZX Clearing’s default capital forecasting indicates that the largest derivatives participant's uncovered stress losses would be $27.6 million and $33.4 million for 2018 and 2019 respectively.

The forecast default fund ranges from $17.6 million to $23.4 million for 2018 and 2019. The largest derivatives participant, which, on forecast, has a market share of 32 percent and 25 percent for 2018 and 2019 respectively, would be required to contribute approximately $5.3 million and $8.4 million, it said.

There will be no cap on the size of the fund but it will grow organically based on the required amount of default capital.

The original purpose of the cap on the default fund was to fix NZX Clearing’s “skin in the game” contribution to a minimum of 25 percent of the overall default fund size.

As the default capital requirement grows to a point that NZX’s contribution may become less than 25 percent of the size of the default capital requirement, NZX Clearing will need to re-evaluate how default capital for the market should be provided, including its own skin in the game and the default fund, it said.


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