Dear Prudence, Won’t You Come Out to Play? Approaches to the Analysis of Central Counter Party Default Fund Adequacy

Bank of England Financial Stability Paper No. 30, 2014

Posted: 14 Nov 2020

See all articles by David Murphy

David Murphy

London School of Economics - Law Department; Bank of England

Paul Nahai-Williamson

Bank of England

Date Written: October 1, 2014

Abstract

Central counter-parties (CCPs) are a key feature of the post-crisis financial system, and it is vital that they are robust. Indeed, as Paul Tucker said, ‘it is an understatement that it would be a disaster if a clearing house failed’ (Tucker (2011)). Therefore the question of how safe CCPs are is an important one. A key regulatory standard for CCPs is ‘cover 2’: this states that systemically important clearing houses must have sufficient financial resources to ‘cover’, or be robust under the failure of, their two largest members in extreme but plausible circumstances. This is an unusual standard, in that it is independent of the number of members a CCP has. Therefore it is natural to ask how prudent the cover 2 standard is for different sizes of CCP. This is the question investigated in this paper.

We first use a simple model to quantify the likelihood of CCP failure. This model is used to produce stylized results showing how the probability of failure of a CCP that meets the cover 2 standard can be estimated. Second, we present a simple approach to explore how the distribution of risk among clearing members affects the prudence of the cover 2 standard. Our results give some reassurance in that we find that CCPs meeting the cover 2 standard are not highly risky provided that tail risks are not distributed too uniformly amongst CCP members. They do however suggest that CCPs and their supervisors should monitor this distribution as central clearing evolves.

Keywords: CCP, CCP Risk, Central Clearing, Central Counter Party, Cover 2

Suggested Citation

Murphy, David and Nahai-Williamson, Paul, Dear Prudence, Won’t You Come Out to Play? Approaches to the Analysis of Central Counter Party Default Fund Adequacy (October 1, 2014). Bank of England Financial Stability Paper No. 30, 2014, Available at SSRN: https://ssrn.com/abstract=3700306

David Murphy (Contact Author)

London School of Economics - Law Department

Houghton Street
London WC2A 2AE, WC2A 2AE
United Kingdom

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Paul Nahai-Williamson

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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