Central Clearing and the Sizing of Default Funds

50 Pages Posted: 3 Dec 2018

See all articles by Agostino Capponi

Agostino Capponi

Columbia University

Jessie Jiaxu Wang

Arizona State University (ASU) - W.P. Carey School of Business

Hongzhong Zhang

Columbia University

Date Written: November 26, 2018

Abstract

We develop a model of central clearing and demonstrate that the current standard for collecting default funds, known as the Cover II rule, is intrinsically vulnerable. Although default funds allow members to share risk ex-post, an inherent externality induces members to take excessive risk ex-ante. Notably, regulating the size of the default fund can mitigate such externality. We solve for an optimal default fund that trades off the cost of funding collateral with the extent of risk-shifting. The optimal default fund covers the default costs of a fraction, rather than of a fixed number, of clearing members.

Keywords: Central counterparties (CCPs), default funds, loss mutualization, externality, risk-shifting

JEL Classification: G20, G23, G28, D61

Suggested Citation

Capponi, Agostino and Wang, Jessie Jiaxu and Zhang, Hongzhong, Central Clearing and the Sizing of Default Funds (November 26, 2018). Available at SSRN: https://ssrn.com/abstract=3290397 or http://dx.doi.org/10.2139/ssrn.3290397

Agostino Capponi

Columbia University ( email )

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

Jessie Jiaxu Wang (Contact Author)

Arizona State University (ASU) - W.P. Carey School of Business ( email )

Tempe, AZ 85287-3706
United States

HOME PAGE: http://www.jiaxuwang.com

Hongzhong Zhang

Columbia University ( email )

3022 Broadway
New York, NY 10027
United States

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