Central Counterparty Risk

Matthias Arnsdorf

counterparty-book

Central counterparties (CCPs) are a key part of the financial system. Their systemic importance is likely to increase further with time as they are viewed as a key mitigant of credit risk and contagion while providing increased transparency to the derivatives market. It is thus critical that the risks of membership to a CCP are well understood and quantified.

Central counterparties are designed to mitigate counterparty risk by holding high levels of collateral and via loss mutualisation. This transforms a large part of the credit risk inherent in bilateral transactions into liquidity risk. However, it also leaves the clearing members exposed to concentrated tail risk. A clearing member of a CCP is exposed to losses on their default fund and potentially on their initial margin contributions. Such losses can be incurred whenever the CCP has insufficient funds to unwind the portfolio of a defaulting clearing member. This does not necessarily require the default of the CCP itself. This risk is explicitly recognised in the Basel III rules that require the capitalisation of default fund exposures.

In this chapter we shall look at how to understand and quantify the risks a bank has

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