Skin in the Game: Risk Analysis of Central Counterparties

51 Pages Posted: 25 Oct 2023 Last revised: 20 Mar 2024

See all articles by Rama Cont

Rama Cont

University of Oxford

Samim Ghamami

Securities and Exchange Commission (SEC); New York University (NYU); University of California, Berkeley - Center for Risk Management Research

Date Written: September 27, 2023

Abstract

This paper introduces an incentive compatibility framework to analyze agency problems linked to central counterparty (CCP) risk management. Our framework, which is based on a modern approach to extreme value theory, is used to design CCP skin-in-the-game (SITG). We show that under inadequate SITG levels, members are more exposed to default losses than CCPs. The resulting risk management incentive distortions could be mitigated by using the proposed SITG formulations. Our analysis addresses investor-owned and member-owned CCPs, we also analyze multilayered and monolayer default waterfalls. Viewing the total size of SITG as the lower bound on CCP regulatory capital, the framework can be used to improve capital regulation of investor-owned and member-owned CCPs. We also demonstrate that bank capital rules for CCP exposures may underestimate risk. The broader central clearing mandate of U.S. Treasuries may take place under monolayer CCPs. These clearinghouses may need to allocate more of their own capital to the default waterfall.

Keywords: central counterparties, agency problems, OTC markets, financial stability, financial regulation

JEL Classification: C54, D82, E58, G23, G28, G33

Suggested Citation

Cont, Rama and Ghamami, Samim, Skin in the Game: Risk Analysis of Central Counterparties (September 27, 2023). Available at SSRN: https://ssrn.com/abstract=4584822 or http://dx.doi.org/10.2139/ssrn.4584822

Rama Cont

University of Oxford ( email )

Mathematical Institute
Oxford, OX2 6GG
United Kingdom

HOME PAGE: http://www.maths.ox.ac.uk/people/rama.cont

Samim Ghamami (Contact Author)

Securities and Exchange Commission (SEC) ( email )

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Washington, DC 20549-1105
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New York University (NYU) ( email )

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University of California, Berkeley - Center for Risk Management Research ( email )

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