Clearinghouse Default Waterfalls: Risk-Sharing, Incentives, and Systemic Risk

39 Pages Posted: 9 Mar 2017 Last revised: 31 Aug 2017

See all articles by Agostino Capponi

Agostino Capponi

Columbia University

W. Cheng

AQR Capital Management, LLC

Jay Sethuraman

Columbia University

Date Written: August 30, 2017

Abstract

Central to the ongoing debate on default resource adequacy are the incentives provided by the clearinghouse waterfall structure. We show that clearinghouse equity and member default funds play a complementary role to initial margins: they incentivize safe members to participate rather than deterring risky ones from not participating. Our results explain the empirical differences in capitalization and profitability across clearinghouses, and show that temporary low funding cost environments create the illusion that clearinghouses are adequately capitalized. The model sheds normative insights: minimum equity requirements can impose additional costs on members because the clearinghouse's equilibrium response is to increase default funds.

Keywords: clearinghouses, risk-sharing, funding costs, default waterfall

JEL Classification: G20, G28, G15

Suggested Citation

Capponi, Agostino and Cheng, Wan-Schwin and Sethuraman, Jay, Clearinghouse Default Waterfalls: Risk-Sharing, Incentives, and Systemic Risk (August 30, 2017). Available at SSRN: https://ssrn.com/abstract=2930099 or http://dx.doi.org/10.2139/ssrn.2930099

Agostino Capponi (Contact Author)

Columbia University ( email )

S. W. Mudd Building
New York, NY 10027
United States

Wan-Schwin Cheng

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Jay Sethuraman

Columbia University ( email )

3022 Broadway
New York, NY 10027
United States

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