Contagion in Derivatives Markets

Abstract

A major credit shock can induce large intraday variation margin payments between counterparties in derivatives markets, which may force some participants to default on their payments. These payment shortfalls become amplified as they cascade through the network of exposures. Using detailed Depository Trust & Clearing Corporation data, we model the full network of exposures, shock-induced payments, initial margin collected, and liquidity buffers for about 900 firms operating in the U.S. credit default swaps market. We estimate the total amount of contagion, the marginal contribution of each firm to contagion, and the number of defaulting firms for a systemic shock to credit spreads. A novel feature of the model is that it allows for a range of behavioral responses to balance sheet stress, including delayed or partial payments. The model provides a framework for analyzing the relative effectiveness of different policy options, such as increasing margin requirements or mandating greater liquidity reserves. This paper was accepted by Karl Diether, finance.

How safe are central counterparties in credit default swap markets?

“…These changes in CDS contract values induce variation margin payment obligations between counterparties. 4 20164 For more detail on the methodology underpinning these computations see Paddrik et al (2019).…”

“…A similar model is used inPaddrik, Rajan and Young (2019) to analyze the extent to which the CCP contributes to network contagion.…”

“…We always assume that the CCP engages in variation margin gains haircutting (i.e., soft default) even when all other firms engage in hard default, due to the CCP's contractual obligations to its members. AlthoughΦ(p) is not continuous in p, it is upper semicontinous and monotone decreasing in p, hence it has a greatest fixed point (seePaddrik et al (2019) for details).…”

Simulating Liquidity Stress in the Derivatives Market

“…Our paper is most closely related to Paddrik et al (2018), which also simulates margin calls and liquidity shortfalls in the derivatives market. There are, however, some differences in scope and methodology between the two papers.…”

“…There are, however, some differences in scope and methodology between the two papers. First, Paddrik et al (2018) focus on the US CDS market, which they cover in its entirety (around 900 institutions).…”