Identifying historical episodes for central counterparty stress testing

David Murphy and David Macdonald

Journal of Financial Market Infrastructures

Abstract: ABSTRACT The need to ensure that central counterparties (CCPs) are robust even in crisis conditions;has intensified the focus on stress testing. One question of interest is how to;select a scenario that will be stressful to a given CCP. This paper is a contribution;to the study of stress scenarios. We focus on historical scenarios, studying various;definitions of "stress event" based on a long data set of risk factors. Our results show;that both systemic and idiosyncratic stresses are important: a CCP may find itself;most exposed in either a broad market disruption, such as the events around the failure;of Lehman Brothers, or a more localized event in one market (or a small set;of linked markets). We show that the stressed value-at-risk calculated using different;stress periods varies by a factor exceeding 4. Moreover, the maximum historical;loss on the risk factors studied exceeds the 99.9th percentile of fitted distributions;by a factor averaging 1.38. These results highlight the importance of including the;worst historical episodes in stress testing and, more broadly, the need for care in;selecting the appropriate historical stresses. The paper concludes by suggesting that;enhanced prudential standards for the selection of stressed historical episodes would be beneficial. These CCP-specific scenarios could be supplemented but not replaced by a requirement to conduct standardized stress testing using data from broad market disruptions.

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