Central Clearing and the Sizing of Default Funds
50 Pages Posted: 3 Dec 2018
Date Written: November 26, 2018
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: Suggested Citation