How Clearing Members Share Losses in a Crisis

The Day the Music Stopped

September 10, 2018. A Norwegian trader named Einar Aas has been shorting Nordic power spreads for months. He runs a one-man operation. No company. Just him, trading size that would make hedge funds nervous.

Then power prices spike. Hard. Aas faces margin calls he cannot meet. His positions are underwater by over €100 million.

NASDAQ Clearing — the CCP for Nordic commodities — declares him in default. They start closing his positions. But the market is illiquid. They can't exit at fair prices. The hole keeps getting deeper.

When the dust settles, the loss is €114 million. Aas's own margin? €7 million.

Where does the other €107 million come from?

"I traded prudently my entire career. I managed risk properly. And then I got a bill for someone else's gambling. That's mutualization."

— Clearing Member, Post-Aas Default

The Social Contract of Clearing

Central clearing works because of a bargain: everyone pools resources to guarantee everyone else's trades.

It's financial socialism in a capitalist market. You compete fiercely against other members for profits. But when catastrophe strikes, you're on the same lifeboat.

The mechanism for this is called the default waterfall — a layered structure that determines who loses money, and in what order, when a member cannot pay.

Notice layer 4. That's where the mutualization happens. If the defaulter's resources are exhausted, the CCP reaches into everyone else's pre-funded contributions and uses that money to cover losses.

You traded conservatively. You didn't touch Nordic power spreads. Doesn't matter. Your capital is on the line because you chose to be a clearing member.

The Default Fund: Your Mandatory Insurance Premium

Every clearing member must contribute to the default fund — also called the "guaranty fund" or "clearing fund."

This is cash or high-quality collateral parked at the CCP. You don't earn much on it. You can't use it for trading. It just sits there, waiting for disaster.

In the Aas default, NASDAQ Clearing's default fund was approximately €166 million. They used about €107 million of it — around two-thirds.

Every non-defaulting member woke up to discover their capital had been partially wiped out. Not because of their trades. Because of one Norwegian power trader.

The Allocation Algorithm: Who Pays How Much

Default fund losses aren't split equally. CCPs use formulas to allocate the pain — usually proportional to each member's contribution.

Simple example:

The irony: the largest, most systemically important members pay the most. They're also often the ones with the best risk management. They subsidize the failures of others.

"We run billions through that CCP. Our contribution is huge. When someone with 1% of our volume blows up, we still pay 40% of the losses. That's the deal, but it stings."

— Risk Officer, Global Investment Bank

CCP Skin-in-the-Game: Why They Go Before You

Notice in the waterfall: CCP capital is used before members' default fund contributions. This is called "skin in the game" (SITG).

Why does this matter? Incentives.

If the CCP didn't have its own money at risk, it might be too relaxed about margining. It might let risky members stay. It might not pursue collections aggressively.

By putting CCP capital first, regulators ensure the clearing house has personal motivation to manage risk properly.

In the Aas case, NASDAQ Clearing's SITG was approximately €7 million. After it was exhausted, the rest came from members.

Assessments: The Bill That Follows

What if the default fund isn't enough? What if losses exceed even the mutualized pool?

CCPs have a nuclear option: assessments. They can call members for additional capital — above and beyond what was originally contributed.

This is the "rights of recourse" layer in the waterfall. And it's terrifying.

Assessment rights create an interesting dynamic: CCPs want them for safety, but members want to limit them for predictability.

The result is elaborate negotiation over rulebook terms. Members pay lawyers millions to scrutinize these clauses.

The Moral Hazard Problem

Loss mutualization creates a classic moral hazard:

If my failures are partially paid by others, I might take more risk. The costs are socialized; the profits are private.

CCPs try to address this with:

The Aas case exposed gaps: one individual, trading alone, accumulated positions that could threaten the entire CCP. How did that happen?

After the default, NASDAQ Clearing was criticized heavily. Margin models were deemed inadequate. Position limits too loose. Monitoring too slow.

"We trusted the CCP to manage risk. We contributed to the default fund assuming their margining was solid. Then we learned it wasn't. We paid for their mistakes."

— Affected Clearing Member

The Aftermath: Replenishment and Rebuilding

After a default consumes part of the default fund, what happens next?

Members must replenish — rebuild the fund to its target size. This typically happens within 30 days.

You just lost €30 million from someone else's default. Now you have to contribute €30 million more to rebuild the fund. Double the pain.

Some members might exit after a default. But if too many leave, the CCP becomes weaker — concentrating risk among fewer participants.

It's a delicate balance. Leave, and you abandon the market. Stay, and you remain exposed to future defaults.

India's Framework: NSCCL's Default Procedures

In India, NSE Clearing Limited (NSCCL) is the CCP for equity derivatives. Their default waterfall follows global principles with local variations:

India has been fortunate: no major clearing member default has tested this waterfall in extreme conditions. But with F&O volumes exploding, the system is under increasing strain.

SEBI has been strengthening requirements: higher capital for members, more robust margining, better position monitoring. The goal is to ensure the waterfall is never tested to its limits.

The Incentive Paradox

Here's the uncomfortable truth about loss mutualization:

You're forced to care about your competitors' risk management.

If JPMorgan trades prudently but Goldman Sachs blows up, JPMorgan pays part of Goldman's losses. If your broker is conservative but a rival broker fails, you might still face costs.

This creates strange incentives:

"We compete in the market but cooperate in the clearing house. We both want tight risk controls — because we're both exposed if they fail. It's the strangest cartel you've ever seen."

— Clearing Member Risk Committee Participant

What This Means For Retail Traders

You're not a clearing member. You trade through your broker, who clears through their clearing member, who faces the CCP.

Why should you care about loss mutualization?

The mutualization model works because it distributes risk. But it also connects you to traders you've never met, in markets you don't trade.

When someone blows up spectacularly, the shockwave reaches everyone.

The Deal We Live With

Loss mutualization is imperfect. It punishes the prudent for the sins of the reckless. It creates moral hazard. It demands members pay for risks they didn't take.

But the alternative is worse: a market where every trade carries counterparty risk. Where you must evaluate the creditworthiness of your trade's other side. Where one failure cascades into a thousand failures.

We choose mutualization because it transforms individual bankruptcy into collective resilience.

Einar Aas lost everything. He went personally bankrupt. But the markets kept trading. Contracts settled. Positions were honored.

The members who paid were furious. But they paid, the fund was replenished, and the system survived.

That's the deal. That's why the plumbing works.