Central Counterparty Default Waterfalls and Systemic Loss

Paddrik, Mark E.; Zhang, Simpson

doi:10.2139/ssrn.3634656

Cited by 9 publications

(6 citation statements)

References 21 publications

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“…Koeppl et al (2012) consider the tradeoff faced by a clearinghouse in providing liquidity to members, while ensuring incentives are in place for carrying out and settling transactions. Paddrik and Zhang (2020) study the optimal default waterfall design to limit clearinghouse losses given a set of exposures. Biais et al (2012) consider whether centralized clearing makes trading parties better off and whether it eliminates counterparty risk of its members.…”

Section: Related Literaturementioning

confidence: 99%

Risk-Sharing and the Creation of Systemic Risk

Acharya

Iyer²,

Sundaram

2020

SSRN Journal

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We address the paradox that financial innovations aimed at risk-sharing appear to have made the world riskier. Financial innovations facilitate hedging idiosyncratic risks among agents; however, aggregate risks can be hedged only with liquid assets. When risk-sharing is primitive, agents self-hedge and hold more liquid assets; this buffers aggregate risks, resulting in few correlated failures compared to when there is greater risk sharing. We apply this insight to build a model of a clearinghouse to show that as risk-sharing improves, aggregate liquidity falls but correlated failures rise. Public liquidity injections, for example, in the form of a lender-of-last-resort can reduce this systemic risk ex post, but induce lower ex-ante levels of private liquidity, which can in turn aggravate welfare costs from such injections.

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Section: Related Literaturementioning

confidence: 99%

Risk-Sharing and the Creation of Systemic Risk

Acharya

Iyer²,

Sundaram

2020

SSRN Journal

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“…Finally, this paper is also related to the literature about central clearing. Duffie and Zhu (2011) started the formal discussion, which is extended by Duffie et al (2015), Arnold (2017), Frei et al (2017), Paddrik and Young (2017), and Paddrik et al (2019) analyzing the effect on systemic risk and margin dynamics under a CCP. Biais et al (2012) uses the search cost as the moral hazard problem of clearing members.…”

Section: Related Literaturementioning

confidence: 99%

“…This structure of participation fee is in fact, how the actual CCP manages its guarantee funds in the CCP's "default waterfall"(Paddrik et al, 2019).…”

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confidence: 99%

Collateralized Debt Networks with Lender Default

Chang

2019

FEDS

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The Lehman Brothers' bankruptcy triggered the failure of the collateralized debt markets, which was a major contributor of the financial crisis in 2008. Such collateralized debt markets have both collateral price channel and counterparty (borrower and lender) channel of contagion. I propose a general equilibrium network model, which incorporates the two channels of contagion by endogenizing leverage (margin), asset prices, and network formation. Agents face a tradeoff between leverage and counterparty risk. Diversification of counterparty risk generates positive externalities by reducing systemic risk, but comes at the cost of lower leverage. Thus, any decentralized equilibrium is inefficient due to under-diversification. I use this framework to show that the loss coverage by a central counterparty (CCP) exacerbates the externality problem and the introduction of CCP can rather increase systemic risk.

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“…7 Our analysis delivers novel predictions about the size of SITG and hence the composition of the default waterfall. Empirically, the ratio of CCP capital to total prefunded resources (CCP capital plus members' collateral) varies substantially across CCPs (Paddrik and Zhang (2020)). We show that SITG relative to either total prefunded resources or CCP profit decreases when the number of members increases, due to the decline in the CCP's agency rent.…”

Section: Introductionmentioning

confidence: 99%

The Design of a Central Counterparty

Kuong¹,

Maurin²

2023

J. Financ. Quant. Anal.

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This article analyzes the optimal allocation of losses via a Central Clearing Counterparty (CCP) in the presence of counterparty risk. A CCP can hedge this risk by mutualizing losses among its members. This protection, however, weakens members’ incentives to manage counterparty risk. Delegating members’ risk monitoring to the CCP alleviates this tension in large markets. To discipline the CCP at minimum cost, members offer the CCP a junior tranche and demand capital contribution. Our results endogenize key layers of the default waterfall and deliver novel predictions on its composition, collateral requirements, and CCP ownership structure.

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Central Counterparty Default Waterfalls and Systemic Loss

Cited by 9 publications

References 21 publications

Risk-Sharing and the Creation of Systemic Risk

Risk-Sharing and the Creation of Systemic Risk

Collateralized Debt Networks with Lender Default

The Design of a Central Counterparty

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