CDS Central Counterparty Clearing Liquidation: Road to Recovery or Invitation to Predation?

67 Pages Posted: 15 Jan 2020

See all articles by Magdalena Tywoniuk

Magdalena Tywoniuk

Swiss Finance Institute, Students; University of Geneva - Geneva Finance Research Institute (GFRI); Swiss Finance Institute, Students

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Date Written: April 26, 2019

Abstract

Recent regulation, mandating the clearing of credit default swaps (CDS) by a Central Clearing Counterparties (CCP), has rendered it's possible failure a serious threat to global nancial stability. This work investigates the potential failure of a CCP initiated by the default of a large dealer bank and the unwinding of its positions. The theoretical model examines variation margin exchange between dealer banks and the price impact of liquidation and predatory selling. It provides a measure of covariance between assets in banks' portfolios; price impact affects assets to varying degrees, based on their relative distance to defaulted assets. Key results show that liquidation lowers CCP profits, and how predation decreases the profits of all members, pushing banks to default. Furthermore, a hybrid CCP (vs. current) structure provides a natural disciplinary mechanism for predation. Also, it is more incentive compatible for the CCP, in expectation of a large loss. A multi-period, dynamic simulation, calibrated to OTC market data, provides parameter sensitivities concerning the magnitude of CCP and predatory bank gains/losses, specifically, the minimisation of those losses with a hybrid fund structure. Furthermore, regulatory implications concerning the timing of liquidity injection for a Lender of Last Resort (LoL) are determined for various liquidity scenarios; stable and decreasing market liquidity, as well as, a liquidity dry-up at the bottom of a financial crisis.

Keywords: Systemic Risk, CCP Recovery, CDS, CDS Spread Fire Sales, Liquidation, Predation, Price Impact, Contagion, Financial Network, Over the Counter Markets

JEL Classification: G00, G01, G02, G14, G10, G18, G20, G23, G33

Suggested Citation

Tywoniuk, Magdalena, CDS Central Counterparty Clearing Liquidation: Road to Recovery or Invitation to Predation? (April 26, 2019). Proceedings of the 4th Chapman Conference on Money & Finance on Liquidity: Pricing, Management and Financial Stability, Available at SSRN: https://ssrn.com/abstract=3519624 or http://dx.doi.org/10.2139/ssrn.3519624

Magdalena Tywoniuk (Contact Author)

Swiss Finance Institute, Students ( email )

c/o University of Geneva
42, Bd du Pont d'Arve
Geneva, CH-1211
Switzerland

HOME PAGE: http://https://pasdedanseuse.wixsite.com/magdalenatywoniuk

University of Geneva - Geneva Finance Research Institute (GFRI) ( email )

Geneva, Geneva
Switzerland

HOME PAGE: http://https://pasdedanseuse.wixsite.com/magdalenatywoniuk

Swiss Finance Institute, Students ( email )

c/o University of Geneva
42, Bd du Pont d'Arve
Geneva, CH-1211
Switzerland

HOME PAGE: http://https://pasdedanseuse.wixsite.com/magdalenatywoniuk

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