This paper introduces a simple model of the default waterfall of a central counterparty (CCP) clearing service to provide an objective analysis of its composition. The three commonly found elements of the waterfall (initial margin, CCP capital at risk or “skin-in-the-game” (SITG), and default fund (DF)) are introduced, and the impact of varying the proportions of each element is discussed. The model suggests that, under reasonable assumptions, CCPs want SITG to be as low as possible, while clearing members prefer services where it plays a larger role in the default waterfall. In our setting, lower levels of SITG lead to a higher CCP return on equity but reduced levels of clearing. Moreover, CCPs have an incentive to keep initial margin higher than the required minimum, as this reduces the risk of DF losses without putting CCP capital at risk. The analysis presented suggests that a regulatory minimum requirement for SITG could play a role in incentivizing the use of CCPs where a clearing mandate does not apply and regulatory capital incentives to clear do not bite.
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