The end of the waterfall: Default resources of central counterparties
Author(s)
Cont, R
Type
Journal Article
Abstract
Central counterparties (CCPs) have become pillars of the new global financial architecture following the financial crisis of 2008. The key role of CCPs in mitigating counterparty risk and contagion has in turn cast them as systemically important financial institutions whose
eventual failure may lead to potentially serious consequences for financial stability, and
prompted discussions on CCP risk management standards and safeguards for recovery and
resolutions of CCPs in case of failure. We contribute to the debate on CCP default resources
by focusing on the incentives generated by the CCP loss allocation rules for the CCP and its
members and discussing how the design of loss allocation rules may be used to align these
incentives in favor of outcomes which benefit financial stability. After reviewing the
ingredients of the CCP loss waterfall and various proposals for loss recovery provisions for
CCPs, we examine the risk management incentives created by different ingredients in the
loss waterfall and discuss possible approaches for validating the design of the waterfall.
We emphasize the importance of CCP stress tests and argue that such stress tests need to
account for the interconnectedness of CCPs through common members and cross-margin
agreements. A key proposal is that capital charges on assets held against CCP Default Funds
should depend on the quality of the risk management of the CCP, as assessed through
independent stress tests.
eventual failure may lead to potentially serious consequences for financial stability, and
prompted discussions on CCP risk management standards and safeguards for recovery and
resolutions of CCPs in case of failure. We contribute to the debate on CCP default resources
by focusing on the incentives generated by the CCP loss allocation rules for the CCP and its
members and discussing how the design of loss allocation rules may be used to align these
incentives in favor of outcomes which benefit financial stability. After reviewing the
ingredients of the CCP loss waterfall and various proposals for loss recovery provisions for
CCPs, we examine the risk management incentives created by different ingredients in the
loss waterfall and discuss possible approaches for validating the design of the waterfall.
We emphasize the importance of CCP stress tests and argue that such stress tests need to
account for the interconnectedness of CCPs through common members and cross-margin
agreements. A key proposal is that capital charges on assets held against CCP Default Funds
should depend on the quality of the risk management of the CCP, as assessed through
independent stress tests.
Date Issued
2015-10-01
Date Acceptance
2015-08-02
Citation
Journal of Risk Management in Financial Institutions, 2015, 8 (4), pp.365-389
ISSN
1752-8887
Publisher
Henry Stewart Publishing
Start Page
365
End Page
389
Journal / Book Title
Journal of Risk Management in Financial Institutions
Volume
8
Issue
4
Copyright Statement
© 2015 Henry Stewart Publications
Publication Status
Accepted
Publisher URL