Central Counterparty Capitalization and Misaligned Incentives
2017 ECB Sintra Forum on Central Banking, 2017 European Financial Association, 2019 American Economic Association
Incentive regulations on central counterparties (CCPs) are essential to financial stability. This paper studies a for-profit CCP's incentives. The trade-off is between fee income and counterparty credit risk. A better-capitalized CCP sets a higher collateral requirement to reduce potential default losses, even though it forgoes fee income by dissuading potential traders. I show empirically that a 1% increase in CCP capital is associated with a 0.6% increase in required collateral. Without capital requirements, a for-profit CCP holds too little capital and demands too little collateral relative to what is socially optimal. The optimal capital requirements should account for clearing fees.
Systemic Risk in Real Time: A Risk Dashboard for Central Clearing Parties (CCPs) R&R Management Science (with Albert J. Menkveld )
Time is valuable, in particular in stressed markets. As central clearing parties (CCPs) have become systemically important institutions, it is desirable to track their exposure towards clearing members in real time. We propose a risk dashboard that not only tracks such exposure, but also offers a decomposition. This enables a CCP to be alerted by sudden large increases, but also to identify their root causes. When implementing the approach on real world data we find fat tails. Zooming in on extreme increases, we find that they are dispro- portionately due to crowded trades among intermediaries --- desirable if motivated by hedging, worrying if due to speculation.