Managing Market Liquidity Risk in Central Counterparties

Abstract

In the event of a clearing member’s default, and as part of its default management process, a central counterparty (CCP) will need to hedge the defaulter’s portfolio and to close-out its positions. However, the CCP may not be able to do this without incurring additional losses if the market is illiquid or if the portfolio contains large and concentrated positions. To mitigate this liquidity risk, CCPs often require members to post additional collateral to the initial margin, in the form of “concentration add-ons”. In the absence of a quantitative regulatory standard for calculating concentration add-ons, this paper discusses the different approaches to incorporating market liquidity risk within a CCP’s default waterfall and the challenges that these approaches pose.

Keywords: Central Counterparties (CCPs); Initial Margin; Liquidity Risk; Concentration Add-Ons; Margin Period of Risk (MPOR)