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Hidden Illiquidity with Multiple Central Counterparties

32 Pages Posted: 7 Nov 2014  

Paul Glasserman

Columbia Business School

Ciamac C. Moallemi

Columbia Business School - Decision Risk and Operations

Kai Yuan

Columbia Business School - Decision Risk and Operations

Date Written: October 30, 2014

Abstract

Regulatory changes are transforming the multi-trillion dollar swaps market from a network of bilateral contracts to one in which swaps are cleared through central counterparties (CCPs). The stability of the new framework depends on the resilience of CCPs. Margin requirements are a CCP’s first line of defense against the default of a counterparty. To capture liquidity costs at default, margin requirements need to increase superlinearly in position size. However, convex margin requirements create an incentive for a swaps dealer to split its positions across multiple CCPs, effectively “hiding” potential liquidiation costs from each CCP. To compensate, each CCP needs to set higher margin requirements than it would in isolation. In a model with two CCPs, we define an equilibrium as a pair of margin schedules through which both CCPs collect sufficient margin under a dealer’s optimal allocation of trades. In the case of linear price impact, we show that a necessary and sufficient condition for the existence of an equilibrium is that the two CCPs agree on liquidity costs, and we characterize all equilibria when this holds. A difference in views can lead to a race to the bottom. We provide extensions of this result and discuss its implications for CCP oversight and risk management.

Keywords: Central clearing, swaps, systemic risk

JEL Classification: G28, G13, G33

Suggested Citation

Glasserman, Paul and Moallemi, Ciamac C. and Yuan, Kai, Hidden Illiquidity with Multiple Central Counterparties (October 30, 2014). Available at SSRN: https://ssrn.com/abstract=2519647 or http://dx.doi.org/10.2139/ssrn.2519647

Paul Glasserman (Contact Author)

Columbia Business School ( email )

3022 Broadway
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New York, NY 10027
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Ciamac C. Moallemi

Columbia Business School - Decision Risk and Operations ( email )

New York, NY
United States

HOME PAGE: http://moallemi.com/ciamac

Kai Yuan

Columbia Business School - Decision Risk and Operations ( email )

New York, NY
United States

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