Central counterparties and their financial resources - a numerical approach

Our Financial Stability Papers are designed to develop new insights into risk management, to promote risk reduction policies, to improve financial crisis management planning or to report on aspects of our systemic financial stability work.
Published on 29 April 2013

Financial Stability Paper No. 19
By Paul Nahai-Williamson, Tomohiro Ota, Mathieu Vital and Anne Wetherilt

New regulatory standards require central counterparties (CCPs) to have robust processes in place to mitigate their counterparty credit risk exposures. At the same time, the standards allow CCPs to tailor their risk management models. This paper considers how CCPs can optimally determine the relative mix of initial margin and default fund contributions in a stylised setting, by balancing the costs of default resources with the expected losses they protect against. Where members are of good credit quality and the probability of experiencing losses is low, the loss-mutualising properties of the default fund are favoured over the defaulter-pays properties of initial margin. Significant tail risks in the markets cleared by the CCP further favour the use of the default fund as a cost-effective insurance against potentially large losses. By contrast, when members are more likely to default or extreme losses are unlikely, the CCP has incentives to maximise the defaulter-pays collateral it takes, and the benefits of the loss-mutualising default fund are reduced. Our numerical results support the recognition that CCPs should have some discretion over how they set the optimal level and composition of their default resources, based on the specific risks of the markets and portfolios that they clear. Our results also show that changes in collateral costs and capital requirements can have a significant impact on a CCP’s optimal risk management choices.

PDFCentral counterparties and their financial resources — a numerical approach


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