What it means
A clearing house stands between the buyer and the seller in many financial trades, guaranteeing that each side will be paid. To do this safely, it collects margin (collateral) from each member and holds extra resources in reserve.
The default fund is one of those reserves. Each clearing member pays into the fund, usually in proportion to the risk its trading creates.
If a member defaults and its margin is not enough to close out its positions, the clearing house uses the defaulter's contribution first and then other resources. Only after that does it use the contributions of the surviving members.
The order in which resources are used is known as the default waterfall. It normally starts with the defaulter's margin, then the defaulter's default fund contribution, then a layer of the clearing house's own capital, and finally the contributions of the other members.
The clearing house's own money in the middle is often called skin in the game, because it gives the operator a reason to manage risk carefully. For members, the default fund is a real cost and a real risk.
Their contribution is tied up as collateral, and they could lose some of it if another member fails badly. Finance teams at banks and brokers therefore treat the exposure to default funds as part of their credit risk and capital planning.
Rules about the size and structure of default funds are set by the clearing house and its regulators, and they change over time. Regulators generally expect the fund to be big enough to cover the failure of the largest members under extreme but plausible market conditions.
Stress tests are run regularly to check this. The design creates a balance of incentives.
Members want the fund to be large enough to be trusted, but they do not want to lock up more collateral than necessary. Clearing houses therefore publish their methods so members can judge the protection they are paying for.
In practice
Real-world examples
Example 1
A futures clearing house requires each of its 40 members to contribute to a default fund based on its trading volume. A mid-sized broker contributes $25,000,000 and counts this as restricted collateral in its liquidity plan.
Example 2
A derivatives clearing house runs a quarterly stress test, imagining the failure of its two biggest members during a sharp price move. The test shows the fund would be short by $200,000,000, and the clearing house asks members to top it up. Members receive a notice explaining how much each must add and by what date.
Example 3
A bank's risk team reviews its contributions to several clearing houses and finds that default fund exposure has risen by 30% in a year. The team adds the extra exposure to its internal capital calculations.
Think of it
Think of a default fund like a neighbourhood fire insurance pool. Every homeowner pays a yearly fee into a shared vault. If one house burns down, the neighbourhood uses the pooled money to rebuild it, ensuring the whole street does not fall into ruin.
Formula
Calculation
Mutualised loss = Total loss - Defaulter's margin - Defaulter's fund contribution - Clearing house capital
Suppose a member defaults and the clearing house suffers a loss of $90,000,000 closing out its positions. The defaulter's margin covers $60,000,000, leaving 90,000,000 - 60,000,000 = $30,000,000. The defaulter's own default fund contribution of $10,000,000 reduces this to $20,000,000, and the clearing house's own capital of $5,000,000 reduces it to $15,000,000. The remaining $15,000,000 is shared among the surviving members using the mutual default fund.Case study
Seen in the real world
Meridian Clearing is an illustrative, fictional clearing house for energy futures with 30 members and a default fund of $600,000,000. During a sudden price spike, a trading firm called Ashgrove Energy failed to meet a margin call and was declared in default.
Ashgrove's margin of $150,000,000 and its default fund contribution of $12,000,000 were used first. The remaining loss was $40,000,000, so the clearing house added $20,000,000 of its own capital and then used $20,000,000 from the mutual fund.
The illustrative outcome was that no other member was forced to fail, and the surviving members were asked to replenish the fund. Several members reviewed their trading limits afterwards, because they realised the shared fund meant a partner's failure could cost them money.
Watch out
Common mistakes
- Confusing the default fund with the margin a member posts for its own positions, when margin protects against that member alone and the fund is shared.
- Assuming members can never lose money in a default, when mutualised losses can reach the contributions of surviving members.
- Ignoring the contribution when planning liquidity, even though the money is locked up and cannot be used for other purposes.
Questions
People also ask
Who contributes to a default fund?
The clearing members of a clearing house contribute, normally in proportion to the size of the risk their trading generates.
What happens if the default fund is used?
The members are usually asked to replenish it, and some rules allow the clearing house to call for further contributions up to a stated limit.
Is the default fund the first line of defence?
No, because the defaulter's own margin and contribution come first, and the shared fund is used only after those layers are exhausted.