Hostname: page-component-78c5997874-s2hrs Total loading time: 0 Render date: 2024-11-02T21:53:45.307Z Has data issue: false hasContentIssue false
  • English
  • Français

Central Counterparty Default Waterfalls and Systemic Loss

Published online by Cambridge University Press:  28 November 2022

Samim Ghamami ,
Mark Paddrik Open the ORCID record for Mark Paddrik [Opens in a new window]  and
Simpson Zhang
Samim Ghamami
Affiliation:
University of California Berkeley Center for Risk Management Research, New York University Courant Institute, and New York University Department of Finance and Risk Engineering [email protected]
Mark Paddrik*
Affiliation:
U.S. Department of the Treasury Office of Financial Research
Simpson Zhang
Affiliation:
Office of the Comptroller of the Currency Market Risk Analysis Division [email protected]
*
[email protected] (corresponding author)
Rights & Permissions [Opens in a new window]

Abstract

Core share and HTML view are not available for this content. However, as you have access to this content, a full PDF is available via the ‘Save PDF’ action button.

Central counterparty (CCP) default waterfalls act as the last lines of defense in over-the-counter markets by managing and allocating resources to cover payment defaults. This article examines the impact of variations in waterfall design on financial system losses in the presence of payment network dependencies and frictions in the cleared and noncleared portion of the system. Through the development of a structural model, we draw several theoretical conclusions about the effectiveness of CCP default waterfalls under severe payment stress. These findings are empirically quantified by testing the model using supervisory data for the U.S. credit default swap market.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 58 , Issue 8 , December 2023 , pp. 3577 - 3612
Copyright
© The Author(s), 2022. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank the anonymous referees, Celso Brunetti, Roy Cheruvelil, Ben Craig, Stéphane Crépey, Peter Curley, Selman Erol, Katherine Gleason, Stephen Kane, David Li, Sriram Rajan, Stacey Schreft, Stathis Tompaidis, Jessie Jiaxu Wang, Robert Wasserman, H. Peyton Young, John Zitko and participants of the 2019 Network Science and Economics Conference, 2019 Canadian Economic Association Annual Meeting, 2019 SIAM Conference on Financial Mathematics and Engineering: CCP Symposium, 2019 Western Finance Association Conference, 2019 Society for Economic Dynamics Meeting, 2019 FDIC/JFSR Bank Research Conference, and 2019 OFR/FRBC Financial Stability Conference for their valuable comments. We thank Elizabeth McKee for her excellent assistance in aggregating CCP filings and analyzing CCP manuals. Additionally, we thank OFR’s High Performance Computing, Data, and Legal teams for collecting and organizing the data necessary to make this project possible. The views expressed in this article do not necessarily reflect the views of the Office of the Comptroller of the Currency, the Office of Financial Research, the U.S. Department of the Treasury, or any federal agency and do not establish supervisory policy, requirements, or expectations.

References

ABN AMRO Clearing; Allianz Global Investors; Barclays; Blackrock; Commonwealth Bank of Australia; Citigroup; Credit Suisse; Deutsche Bank; Franklin Templeton; Goldman Sachs; Guardian; Ivy Investments; Nordea, J. P. Morgan Chase; Societe Generale; State Street; TIAA; Price, T. Rowe; UBS; and Vanguard. “A Path Forward for CCP Resilience, Recovery, and Resolution.” Technical Report, available at https://www.jpmorgan.com/solutions/cib/markets/a-path-forward-for-ccp-resilience-recovery-and-resolution (2020).Google Scholar
Acharya, V., and Bisin, A.. “Counterparty Risk Externality: Centralized Versus Over-the-Counter Markets.” Journal of Economic Theory, 149 (2014), 153–182.CrossRefGoogle Scholar
Amini, H.; Filipović, D.; and Minca, A.. “Systemic Risk in Networks with a Central Node.” SIAM Journal on Financial Mathematics, 11 (2020), 60–98.CrossRefGoogle Scholar
BCBS and IOSCO. “Margin Requirements for Non-Centrally-Cleared Derivatives.” Technical Report, BIS and OICV-IOSCO, Basel, Switzerland (2015).Google Scholar
Benos, E.; Huang, W.; Menkveld, A.; and Vasios, M.. “The Cost of Clearing Fragmentation.” Bank of England Staff Working Paper 800 (2019).CrossRefGoogle Scholar
Biais, B.; Heider, F.; and Hoerova, M.. “Clearing, Counterparty Risk, and Aggregate Risk.” IMF Economic Review, 60 (2012), 193–222.CrossRefGoogle Scholar
Bignon, V., and Vuillemey, G.. “The Failure of a Clearinghouse: Empirical Evidence.” Review of Finance, 24 (2020), 99–128.Google Scholar
Capponi, A.; Cheng, W.-S. A.; Giglio, S.; and Haynes, R.. “The Collateral Rule: Evidence from the Credit Default Swap Market.” Journal of Monetary Economics, 126 (2022), 58–86.CrossRefGoogle Scholar
Capponi, A.; Cheng, W.; and Sethuraman, J.. “Clearinghouse Default Waterfalls: Risk-Sharing, Incentives, and Systemic Risk.” Working Paper, Columbia University (2017).Google Scholar
Cerezetti, F.; Cruz Lopez, J.; Manning, M.; and Murphy, D.. “Who Pays? Who Gains? Central Counterparty Resource Provision in the Post-Pittsburgh World.” Journal of Financial Market Infrastructures, 7 (2019), 21–44.Google Scholar
Cont, R. “The End of the Waterfall: Default Resources of Central Counterparties.” Journal of Risk Management in Financial Institutions, 8 (2015), 365–389.CrossRefGoogle Scholar
Cox, R. T. “Central Counterparties in Crisis: The Hong Kong Futures Exchange in the Crash of 1987.” Journal of Financial Market Infrastructures, 4 (2015), 73–98.CrossRefGoogle Scholar
Cox, R. T., and Steigerwald, R. S.. “A CCP Is a CCP Is a CCP.” Journal of Financial Market Infrastructures, 6 (2018), 1–18.CrossRefGoogle Scholar
CPMI-IOSCO. Recovery of Financial Market Infrastructures. CPMI Papers 162. Basel, Switzerland: Bank of International Settlements; 2017.Google Scholar
Cruz Lopez, J. A.; Harris, J. H.; Hurlin, C.; and Pérignon, C.. “CoMargin.” Journal of Financial and Quantitative Analysis, 52 (2017), 2183–2215.CrossRefGoogle Scholar
D’Errico, M.; Battiston, S.; Peltonen, T.; and Scheicher, M.. “How Does Risk Flow in the Credit Default Swap Market?” Journal of Financial Stability, 35 (2018), 53–74.CrossRefGoogle Scholar
Duffie, D. “Resolution of Failing Central Counterparties.” In Making Failure Feasible: How Bankruptcy Reform Can End ‘Too Big to Fail.’ Jackson, T., Scott, K., and Taylor, J. E., eds. Palo Alto, CA: Hoover Institution Press (2015), 87–109.Google Scholar
Duffie, D.; Scheicher, M.; and Vuillemey, G.. “Central Clearing and Collateral Demand.” Journal of Financial Economics, 116 (2015), 237–256.CrossRefGoogle Scholar
Duffie, D., and Zhu, H.. “Does a Central Clearing Counterparty Reduce Counterparty Risk?” Review of Asset Pricing Studies, 1 (2011), 74–95.CrossRefGoogle Scholar
Eisenberg, L., and Noe, T.. “Systemic Risk in Financial Systems.” Management Science, 47 (2001), 236–249.CrossRefGoogle Scholar
Faruqui, U.; Huang, W.; and Takáts, E.. Clearing Risks in OTC Derivatives Markets: The CCP-Bank Nexus, BIS Quarterly Review Q4. Bank for International Settlements (2018).Google Scholar
Federal Reserve Board. “Stress Tests and Capital Planning: Comprehensive Capital Analysis and Review.” Technical Report, Board of Governors of the Federal Reserve System (2016).Google Scholar
Financial Stability Oversight Council. Financial Stability Oversight Council Annual Report. Washington, DC: U.S. Government Printing Office (2020).Google Scholar
Ghamami, S. “Static Models of Central Counterparty Risk.” International Journal of Financial Engineering, 2 (2015), 1550011.CrossRefGoogle Scholar
Ghamami, S., and Glasserman, P.. “Does OTC Derivatives Reform Incentivize Central Clearing?”. Journal of Financial Intermediation, 32 (2017), 76–87.CrossRefGoogle Scholar
Ghamami, S.; Glasserman, P.; and Young, H. P.. “Collateralized Networks.” Management Science, 68 (2022), 2202–2225.CrossRefGoogle Scholar
Glasserman, P.; Moallemi, C. C.; and Yuan, K.. “Hidden Illiquidity with Multiple Central Counterparties.” Operations Research, 64 (2016), 1143–1158.CrossRefGoogle Scholar
Glasserman, P., and Young, H. P.. “How Likely Is Contagion in Financial Networks?” Journal of Banking & Finance, 50 (2015), 383–399.CrossRefGoogle Scholar
Huang, W. “Central Counterparty Capitalization and Misaligned Incentives.” BIS Working Paper 767 (2019).Google Scholar
Huang, W.; Menkveld, A. J.; and Yu, S.. “Central Counterparty Exposure in Stressed Markets.” Management Science, 67 (2021), 3596–3617.CrossRefGoogle Scholar
Huang, W., and Takáts, E.. The CCP-Bank Nexus in the Time of Covid-19. BIS Bulletin, Vol. 13. Bank for International Settlements (2020a).Google Scholar
Huang, W., and Takáts, E.. “Model Risk at Central Counterparties: Is Skin-in-the-Game a Game Changer?” BIS Working Paper 866 (2020b).Google Scholar
ISDA. “CCP Loss Allocation at the End of the Waterfall.” Technical Report, International Swaps and Derivatives Association, available at https://www.isda.org/2013/08/08/ccp-loss-allocation-at-the-end-of-the-waterfall/ (2013).Google Scholar
ISDA. “CCP Default Management, Recovery and Continuity: A Proposed Recovery Framework.” Technical Report, available at https://www.isda.org/a/KiDDE/ccp-default-management-recovery-and-continuity-26-01-2015.pdf (2015).Google Scholar
Kahros, A.; Pioli, A.; Carraro, T.; Gravanis, M.; and Vacirca, F.. “A Descriptive Analysis of the Client Clearing Network in the European Derivatives Landscape.” Journal of Financial Market Infrastructures, 9 (2021), 95–123.Google Scholar
Kroszner, R. S. “Can the Financial Markets Privately Regulate Risk? The Development of Derivatives Clearinghouses and Recent over-the-Counter Innovations.” Journal of Money, Credit and Banking, 31 (1999), 596–618.CrossRefGoogle Scholar
Kuong, J. C.-F. “Self-Fulfilling Fire Sales: Fragility of Collateralized Short-Term Debt Markets.” Review of Financial Studies, 34 (2021), 2910–2948.CrossRefGoogle Scholar
Li, D., and Cheruvelil, R.. “Study of Correlation Impact on Credit Default Swap Margin Using a GARCHDCC-Copula Framework.” Journal of Financial Market Infrastructures, 8 (2019), 51–92.Google Scholar
Luo, L. S. “Bootstrapping Default Probability Curves.” Journal of Credit Risk, 1 (2005), 169–179.CrossRefGoogle Scholar
Menkveld, A. J. “Crowded Positions: An Overlooked Systemic Risk for Central Clearing Parties.” Review of Asset Pricing Studies, 7 (2017), 209–242.CrossRefGoogle Scholar
Menkveld, A. J., and Vuillemey, G.. “The Economics of Central Clearing.” Annual Review of Financial Economics, 13 (2021), 153–178.CrossRefGoogle Scholar
Mourselas, C., and Smith, R.. “Hedge Fund Parplus Said to be Source of ABN’s $200m Loss.” Risk.net, available at https://www.risk.net/derivatives/7514381/hedge-fund-parplus-said-to-be-source-of-abns-200m-loss (2020).Google Scholar
Murphy, D. “I’ve Got You Under my Skin: Large Central Counterparty Financial Resources and the Incentives they Create.” Journal of Financial Market Infrastructures, 5 (2017), 57–74.CrossRefGoogle Scholar
Murphy, D., and Nahai-Williamson, P.. “Dear Prudence, Won’t You Come Out to Play? Approaches to the Analysis of Central Counterparty Default Fund Adequacy.” Bank of England Financial Stability Paper No. 30 (2014).Google Scholar
Paddrik, M.; Rajan, S.; and Young, H. P.. “Contagion in Derivatives Markets.” Management Science, 66 (2020), 3603–3616.CrossRefGoogle Scholar
Paddrik, M., and Young, H. P.. “Assessing the Safety of Central Counterparties.” Office of Financial Research Working Paper 21-02 (2021a).CrossRefGoogle Scholar
Paddrik, M., and Young, H. P.. “How Safe Are Central Counterparties in Credit Default Swap Markets?” Mathematics and Financial Economics, 15 (2021b), 41–57.CrossRefGoogle Scholar
Wang, J. J.; Capponi, A.; and Zhang, H.. “A Theory of Collateral Requirements for Central Counterparties.” Management Science, 68 (2022), 6355–7064.CrossRefGoogle Scholar
Supplementary material: File

Ghamami et al. supplementary material
Download undefined(File)
File 672.6 KB