Central counterparties can no longer rely on a segmented and naive approach to settlement because of the increased interconnectedness and complexity across markets and asset classes. The authors’ closeout risk evaluation (CORE) method represents a significant step in controlling the effect of systemic risk on the portfolio management process.

Clearinghouses have served as effective intermediaries for financial transactions with very few failures. Their ability to manage risk through a well-orchestrated prioritization of transaction settlement using netting, collateralization, and default processes is paramount. But clearinghouses have struggled to keep pace with the ever-increasing complexity of financial products. The demutualization and merger of many of the larger clearing entities transformed them into multi-asset-class behemoths functioning in a very complex latticework of global financial markets. Characterized by greater heterogeneity, this environment demands a better procedure to manage default and mitigate risk.

The authors present their CORE methodology to address these issues. Risk management has evolved markedly over time, revealing and improving on numerous deficiencies to better capture and evaluate exposures. Value at risk (VaR), the forebear of risk measurement, expresses financial loss through a single figure at a given confidence level. Such an approach fails to recognize the factious nature of default that occurs more along a continuum than at a mere two points in time, in different asset classes and markets. The silo approach, which segregates asset classes and manages their risks separately, may increase margin demands and fail to recognize interrelated hedges that could reduce risk more effectively.

The CORE approach recognizes the dynamic nature of the closeout process as a function of product and market complexity. Settlement is not an all-or-nothing proposition but rather a sequence of liquidations over time that accommodates various product constraints and takes into account market value changes as part of the process. Sequencing and prioritization are critical to this methodology. Risk budgeting underpins the entire process.

Chief risk officers as well as portfolio managers and financial market economists should pay heed to the authors’ conclusions and methodology.

The authors reference key elements of financial theory to provide proper context to their discussion of the CORE approach. From there, they put forth a quantitative discussion of what a closeout does and how it is supposed to operate.

A portfolio aggregates heterogeneous exposures that the central counterparty faces in addition to collateral assets that include cash. Proper, or positive, closeout is one where sufficient collateral exists to settle. The opposite is negative closeout, where there is inadequate margin.

Closeout may entail settling all investments at once—which is typically unadvisable—or orchestrating an orderly sequence of liquidation that considers rules and constraints applicable to different asset classes and exposures. The ideal exercise effects settlement with as little risk as possible, which means both protecting the central counterparty and mitigating market disruptions, an increasingly difficult task with more complex financial instruments that may pose settlement issues. Closeout risk metrics consider not only total permanent loss, or what is forgone in the settlement process, but also total transient loss, or extra provisions required beyond permanent loss to address any liquidity gaps during the closeout process.

Any solution must be robust to cash flow mismatches and price variations while preserving natural hedges and minimizing liquidity and market risks in the face of varying constraints. These risks can encompass complete closeout, decreasing inventory, no partial liquidation, execution lag, and market depth limitations.

The authors simulate a scenario that contrasts a naive closeout process with a more nuanced approach that prioritizes and sequences the liquidation process, illustrating the latter’s superiority over the former in terms of risk mitigation.

The authors also reference the implementation and testing of the CORE approach on actual BM&FBOVESPA derivatives in the Brazilian market from September 2008 to February 2009, in which they consider more than 4,000 observations. Again, they contrast naive against nuanced closeout approaches. The CORE method typically outperforms, save for certain highly illiquid portfolios with often insurmountable hedging constraints.

As markets’ complexity increases, the evolution of risk management continues apace. Robust settlement procedures recognize the intertwined character of global markets and the (a)symmetric risk profile of the financial products that attempt to capture such interrelationships. Applying such an approach as the CORE method to other risk intermediaries would be a worthwhile exercise. The one constant in risk management is change.