Central Counterparties and Their Financial Resources – A Numerical Approach

28 Pages Posted: 9 May 2013 Last revised: 29 May 2013

Date Written: April 29, 2013

Abstract

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.

Suggested Citation

Nahai-Williamson, Paul and Ota, Tomohiro and Vital, Mathieu and Wetherilt, Anne, Central Counterparties and Their Financial Resources – A Numerical Approach (April 29, 2013). Bank of England Financial Stability Paper No. 19, Available at SSRN: https://ssrn.com/abstract=2262222 or http://dx.doi.org/10.2139/ssrn.2262222

Paul Nahai-Williamson (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Tomohiro Ota

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Mathieu Vital

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Anne Wetherilt

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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