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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Sat, 17 Apr 2010

Lehman and the Derivative Exchanges

The unredacted Volume 5 of the Lehman examiner’s report released earlier this week provides details about how CME handled the Lehman default by auctioning the positions of Lehman to other large dealers. The table below summarizes the data given in the report.

Asset ClassNegative Option ValueSpan Risk MarginTotal CollateralPrice paid by CME to buyerLoss to ExchangePercentage Loss to ExchangeLoss to Lehman
Energy Derivatives3722616337077412%335
FX Derivatives-41282-6-72%6
Interest Rate Derivatives9313022333311049%240
Equity Derivatives-5737732445-287-39%450
Agricultural Derivatives-555505224%57
Total auctioned by CME451119516461539-107-6%1088
Natural Gas Derivatives sold by Lehman itself482129611622112%140
Grand Total933132422572161-96-4%1228

The negative option value is as the close of business before the Lehman bankruptcy and the loss to Lehman is computed as the excess of the price paid by CME to the buyer over this negative option value. Futures positions are presumably assumed to have zero value after they have been marked to market. On the other hand, CME incurs a loss only if it pays a price in excess of the collateral provided by Lehman. For comparison purposes, the same computation is done for the positions sold by Lehman itself, though, in this case, the exchange does not make any profit or loss.

What I find puzzling here is that in the case of interest rate derivatives, CME had to pay the winning dealer a price of about 1.5 times the collateral available. Had it not been for excess collateral in other asset classes, the CME might have had to take a large loss. Was the CME seriously undermargined or was the volatility in the days after Lehman default so high or was this the result of a panic liquidation by the CME?

We do have an independent piece of information on this subject. LCH.Clearnet in London also had to liquidate Lehman’s swap positions amounting to $9 trillion of notional value. LCH has stated here and here that the Lehman “default was managed well within Lehman margin held and LCH.Clearnet will not be using the default fund in the management of the Lehman default.”

A number of questions arise in this context:

In the context of the ongoing debate about better counterparty risk management (including clearing) of OTC derivatives, I think the regulators should release much more detailed information about what happened. Unfortunately, in the aftermath of the crisis, it is only the courts that have been inclined to release information – regulators and governments like to regard all information as state secrets.

Posted at 19:56 on Sat, 17 Apr 2010     View/Post Comments (2)     permanent link