The End of the Waterfall: Default Resources of Central Counterparties

41 Pages Posted: 27 Apr 2015 Last revised: 23 May 2015

Multiple version iconThere are 2 versions of this paper

Date Written: February 2, 2015


Central counterparties (CCPs) have become pillars of the new global financial architecture following the financial crisis of 2008. The key role of CCPs in mitigating counterparty risk and contagion has in turn cast them as systemically important financial institutions whose eventual failure may lead to potentially serious consequences for financial stability, and prompted discussions on CCP risk management standards and safeguards for recovery and resolutions of CCPs in case of failure.

This note contributes to the debate on CCP default resources by focusing on the incentives generated by the CCP loss allocation rules for the CCP and its members and discussing how the design of loss allocation rules may be used to align these incentives in favor of outcomes which benefit financial stability. After reviewing the ingredients of the CCP loss waterfall and various proposals for loss recovery provisions for CCPs, we examine the risk management incentives created by different ingredients in the loss waterfall and discuss possible approaches for validating the design of the waterfall.

We emphasize the importance of CCP stress tests and argue that such stress tests need to account for the interconnectedness of CCPs through common members and cross-margin agreements. A key proposal is that capital charges on assets held against CCP Default Funds should depend on the quality of the risk management of the CCP, as assessed through independent stress tests.

Keywords: central clearing, CCP, systemic risk, Dodd-Frank, Basel III, EMIR, OTC markets, default risk, financial stability, regulation

JEL Classification: G23, G28, G33, E58

Suggested Citation

Cont, Rama, The End of the Waterfall: Default Resources of Central Counterparties (February 2, 2015). Available at SSRN: or

Rama Cont (Contact Author)

University of Oxford ( email )

Mathematical Institute
Oxford, OX2 6GG
United Kingdom

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