Central Clearing and the Sizing of Default Funds

Wang, Jessie Jiaxu; Capponi, Agostino; Zhang, Hongzhong

doi:10.2139/ssrn.3290397

Cited by 3 publications

(10 citation statements)

References 15 publications

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“…Due to a process called novation, the contractual obligation between the trading parties can be substituted by two equivalent positions between the original trading parties and the clearinghouse (Capponi et al, 2018). As a result, the CCP becomes each seller's buyer and each buyer's seller (KELER KSZF, 2019).…”

Section: Central Clearingmentioning

confidence: 99%

“…Their main finding was that the calculation of the size of the default fund for covering insolvency was not prudent enough only when the default of the two largest clearing members was taken into account, and only very conservative default funds, which cover the exposure of several clearing members, are suitable for restraining the spill-over effect of the stress. Capponi et al (2018) developed a central clearing model, and they proved that the current standard for collecting the default funds -the rule of members with the largest exposure -was basically vulnerable. In their model, they demonstrate that, instead of covering the default by a specific number of members, the clearinghouse should use the entire default fund contribution to cover the specific part of the arising losses.…”

Section: Literature On Stress Testsmentioning

confidence: 99%

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The stress tests of central counterparties in the case of separate default funds - Planning the default fund and calculating its size

Friesz¹,

Muratov-Szabó²,

Prepuk³

et al. 2020

Economy & finance

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The crisis of 2008 pointed out the weaknesses of the current financial system. Since then, the role of central counterparties (CCP) has become increasingly important. CCPs provide guarantee, i.e., they take over the counterparty risk arising in the course of trading on different markets and guarantee the settlement of transactions. To fulfil this role, the CCP has to maintain financial resources which, in the event of the clearing member's default, are sufficient to cover the arising losses. For this purpose, the CCP operates a guarantee system, one element of this is the clearing members' contributions to the default fund. Our study focuses on the structure of the default fund operated by the CCP, as well as the stress test used for the calculation of the size of it. The results point out that we cannot rely solely on historical data when calculating the default fund. It is evident that excluding the outlier results, which are so-called "extreme but plausible," and building the default fund exclusively on historical data could be misleading, and the system could suffer unexpected and significant losses. Based on the risk mentioned above, hypothetical scenarios must be considered in the course of calculation so that the CCP can be prepared for unexpected losses.

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Section: Central Clearingmentioning

confidence: 99%

Section: Literature On Stress Testsmentioning

confidence: 99%

The stress tests of central counterparties in the case of separate default funds - Planning the default fund and calculating its size

Friesz¹,

Muratov-Szabó²,

Prepuk³

et al. 2020

Economy & finance

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show abstract

“…Previous studies have examined loss sharing and its interaction with CCP collateral and fee policies (Capponi, Cheng, and Sethuraman (2017), Capponi and Cheng (2018), Huang (2018)) as well as its impact on clearing members' propensity to engage in risk-shifting (Biais, Heider, and Hoerova (2016), Capponi et al (2019)). In a simulation study, Lewandowska (2015) shows that loss sharing may reduce loss concentration and counterparty risk exposure compared to bilateral netting in the absence of systematic risk, extreme events, or heterogeneous portfolio directionality.…”

Section: Literature Reviewmentioning

confidence: 99%

“…Central clearing primarily relies on two components: multilateral netting (i.e., offsetting of gains and losses across clearing members; see, e.g., Duffie and Zhu (2011) and Cont and Kokholm (2014)) and loss sharing (i.e., mutualization of default losses among clearing members; see, e.g., Huang (2018) and Capponi, Wang, and Zhang (2019)). Despite the increasing importance of central clearing in derivatives markets, research on the impact of these mechanisms on counterparty risk is still scarce.…”

mentioning

confidence: 99%

The Pitfalls of Central Clearing in the Presence of Systematic Risk

2018

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Through the lens of market participants' objective to minimize counterparty risk, we investigate central clearing in derivatives markets, and its interaction with systematic risk, portfolio directionality, and loss sharing. Previous studies suggest that central clearing always reduces counterparty risk for a sufficiently large number of clearing members. We show that this is not the case-mostly because of loss sharing. Central clearing can increase counterparty risk, particularly during extreme market events, for traders with directional portfolios, and because CCPs mutualize default losses. Our results are consistent with the reluctance to clear derivative trades in the absence of a clearing obligation.

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“…For additional liquidity, the CCP may be forced to request a contribution from selective members, for example, based on the proportion of open position or volume (Capponi et al, 2018). Although France and Kahn (2016) point out that the clearing member is not legally obligated to provide these additional o Qualitative and quantitative criteria must be set.…”

Section: The Second Layer Of the Default Waterfall: Default Fundmentioning

confidence: 99%

Central Counterparties : Risk management of central counterparties focusing on the analysis of stress tests

Friesz¹

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My thesis focuses on central counterparties (CCPs) and the stress tests they perform to achieve a resistant operation and therefore increase market resilience. CCPs’ role is to take over the counterparty risk during trading. A CCP needs to operate a multi-level guarantee system that can absorb losses of clearing members’ defaults to fulfill its role. One of the main focal points of my research is to analyze how the size of the guarantee system changes and how the cross-guarantee undertaking changes between clearing members and markets if the CCP merges the guarantee systems of different markets. This question is essential from a financial stability perspective since the guarantee system’s size and structure will affect the loss-absorbing capacity of a CCP. Monte Carlo simulation was used to simulate a 30 years time series for three different products, which gave the basis for the Value-at-Risk-based margin calculation and the stress test-based default fund calculation. Results show that merging the guarantee systems will always decrease the total value of the guarantees because the margin will decrease, which cannot be offset by the increase in the default fund size. In conclusion, it is not optimal from the financial stability perspective to merge the guarantee systems. However, merging is more suitable if the CCP wants to provide cheaper services or if the clearing members are willing to cross-guarantee each other. In order to increase efficiency and to analyze and align the incentives of the CCP and its clearing members, I decided to use the model presented above to shows how the CCP’s own contribution in the default waterfall is affected in different market structures. The model needed to be simplified to perform a sensitivity test on the skin-in-the-game. Overall, the model is improved, and all three layers of the default waterfall are part of the stress testing, so results are based on the whole default waterfall rather than just a part of it and therefore reached more sophisticated conclusions. The proposed model shows how the CCP’s own contribution in the default waterfall is affected in different structures. It is an important question since this own contribution is being financed from the capital of the CCP. So the larger this contribution is, the larger the stake of the CCPs’ capital is risked. Results for the four different operations are as follows: • The merged market scenario is risky for the CCP since it offers the lowest value for the overall default waterfall, and also, the CCP has to provide the second largest SITG value compared to the fully or partially separated - IM structures. This setup is favorable for some members engaging in risky trading and also affects clearing members’ liquidity the least. In the long run, the CCP would need a tremendous amount of capital to support the system, mainly if it aims to protect non-defaulting members. However, to avoid resolution, the CCP relies on the fund provided by the non-defaulting members. Due to the heightened level of loss-mutualization, this setup is disadvantageous for members active only on one of the cleared markets. • The separated design gives an advantage to the CCP, but it is not beneficial for minor participants from the market because the clearing activity can become too costly. • The default fund level separation setup was the least favorable since it required the highest SITG, while the members had a higher default fund contribution obligation. • The partially separated - IM one was proven to be the most suitable for all stakeholders. It brings the benefits of a higher margin requirement and smaller SITG for the CCP, but members can profit from hedging and risk-mutualization on a default fund level, ultimately, this being the best compromise between parties.

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Central Clearing and the Sizing of Default Funds

Cited by 3 publications

References 15 publications

The stress tests of central counterparties in the case of separate default funds - Planning the default fund and calculating its size

The stress tests of central counterparties in the case of separate default funds - Planning the default fund and calculating its size

The Pitfalls of Central Clearing in the Presence of Systematic Risk

Central Counterparties : Risk management of central counterparties focusing on the analysis of stress tests

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