In the aftermath of the global financial crisis, Central Counterparties (CCPs) are introduced for a large amount of asset classes by regulators around the world (e.g., Dodd-Frank Act in the U.S. and EMIR in the EU). CCPs become systemic nodes in financial markets (Bernanke, 2011). Proper incentive regulations on CCPs are critical for financial stability. In my job market paper, titled “Central Counterparty Capitalization and Misaligned Incentives”, I study the incentive problem and optimal regulations for a profit-driven CCP with limited liability.
What are Central Counterparties (CCPs)?
Central Counterparties are financial market infrastructures that stand between buyers and sellers, which are normally referred as clearing members (CPMI-IOSCO, 2012). Figure 1 illustrates CCP’s role. Through the “novation” process, a contract between a buyer and a seller splits into two: one is between the buyer and the CCP; the other is between the CCP and the seller. Hence, the CCP, legally and literally, becomes the “central counterparty” to all his clearing members.
CCPs provide insurance against counterparty risk. When a clearing member defaults, he defaults at the CCP. To prepare a CCP for potential default losses, there are pre-funded financial resources, which is called “default-waterfall”. Figure 2 shows a standard “default-waterfall”. The default losses will first be covered by the collateral (initial margin and variation margin) and default fund contributed by the defaulters. These two layers constitute the collateralized financial resources. Then, the remaining losses will be covered by the skin-in-the-game (SITG) contributed by the CCP. If this layer drains out, default fund contributed by other non-defaulters will be used, which is the last layer of the pre-funded financial resources. At the end of the waterfall, the CCP either resolve, which means transforming back to bilateral clearing, or recover, which means allocate the remaining losses to the clearing members.
What are Central Counterparties (CCPs)?
Central Counterparties are financial market infrastructures that stand between buyers and sellers, which are normally referred as clearing members (CPMI-IOSCO, 2012). Figure 1 illustrates CCP’s role. Through the “novation” process, a contract between a buyer and a seller splits into two: one is between the buyer and the CCP; the other is between the CCP and the seller. Hence, the CCP, legally and literally, becomes the “central counterparty” to all his clearing members.
CCPs provide insurance against counterparty risk. When a clearing member defaults, he defaults at the CCP. To prepare a CCP for potential default losses, there are pre-funded financial resources, which is called “default-waterfall”. Figure 2 shows a standard “default-waterfall”. The default losses will first be covered by the collateral (initial margin and variation margin) and default fund contributed by the defaulters. These two layers constitute the collateralized financial resources. Then, the remaining losses will be covered by the skin-in-the-game (SITG) contributed by the CCP. If this layer drains out, default fund contributed by other non-defaulters will be used, which is the last layer of the pre-funded financial resources. At the end of the waterfall, the CCP either resolve, which means transforming back to bilateral clearing, or recover, which means allocate the remaining losses to the clearing members.
What could go wrong with CCPs?
Although CCPs are systemically important, many CCPs operate as profit-driven financial firms with limited liability, such as CME in the U.S. and Eurex in the EU. There are potential conflicts between CCPs’ systemic role and their profit-driven characters. Do CCPs have high enough SITG to align proper incentives?
In general, CCPs have a thin layer of SITG, compared to the overall pre-funded financial resources. Figure 3 is a scatter-plot of CCPs’ SITG versus default fund based on the 2016 quantitative disclosure results. Most of the CCPs’ SITG are less than 1% of their default funds.
What makes CCPs different from banks?
CCPs are different from banks though they share some similarities. Figure 4 compares the balance sheets of a CCP and that of a bank. A CCP is like a bank with passive asset management. In other words, clearing members “deposit” their collateral in the CCP when they initiate trades and “withdraw” the collateral when they terminate trades. Thus, the collateral at the liability side of the CCP is like the bank’s debt; and the CCP’s SITG is like the bank’s equity. However, there is no maturity mismatch between a CCP’s liability side and asset side.
CCPs are different from banks though they share some similarities. Figure 4 compares the balance sheets of a CCP and that of a bank. A CCP is like a bank with passive asset management. In other words, clearing members “deposit” their collateral in the CCP when they initiate trades and “withdraw” the collateral when they terminate trades. Thus, the collateral at the liability side of the CCP is like the bank’s debt; and the CCP’s SITG is like the bank’s equity. However, there is no maturity mismatch between a CCP’s liability side and asset side.
A CCP is different from a bank mainly because of the additional layer at the liability side – the mutualized resources. When someone defaults, the default fund contributed by the clearing members who do not default may be used. The role of the mutualized resources is two-fold. On the one hand, when there are exogenous negative aggregate shocks, the mutualized resources build additional buffer to safeguard CCP solvency. On the other hand, the mutualized resources create an incentive for risk-taking, which leads to endogenous systemic risk.
Key results from a partial-equilibrium model
I construct a partial-equilibrium model based on Biais, Heider, and Hoerova (2016). There are two dates (t = 0, 1), a mass-one continuum of risk-averse protection buyers, a mass-one continuum of heterogeneous risk-neutral protection sellers and a risk-neutral profit-driven CCP. Conditional on available capital, the CCP fine-tunes collateral requirements to balance fee incomes against counterparty risk. High collateral reduces potential default losses, but leads to foregone profitable trades. There are several key results.
- Without capital requirement for CCPs, a profit-driven CCP chooses the minimum capital, whereas a benevolent CCP will favor high capital when capital cost is low. The low SITG chosen by a profit-driven CCP leads to insolvency problem.
- A higher SITG gives rise to a higher collateral requirement, increasing trading cost. Figure 5 shows the optimal collateral policy chosen by a profit-driven CCP. When the CCP has a higher capital (K), the CCP will set a higher collateral (c).
- Profit-maximization and limited liability create a wedge between the profit-driven CCP’s collateral policy and the socially optimal collateral level. Figure 6 shows that capital regulations on profit-driven CCPs can align their incentives and close the wedge when clearing fee is smaller than a threshold. It suggests that clearing fee could be an informative variable when regulators consider optimal capital requirements.
You can find the paper here, and the slides here.
References
Bernanke, Ben. 2011. “Clearinghouses, financial stability, and financial reform.”
Biais, Bruno, Florian Heider, and Marie Hoerova. 2016. “Risk-sharing or Risk-taking? Counter- party Risk, Incentives and Margins.” Journal of Finance 71 (4):1669–1698.
CPMI-IOSCO. 2012. “Principles for Financial Market Infrastuctures.”