Skin in the game

Dennis McLaughlin

Abstract

This paper analyzes the cost of putting  aside capital as skin in the game (SITG). It shows first that under the powers granted to a central counterparty (CCP) by its rule-book, the need for CCP capital is primarily driven by the nondefault loss exposure profile, and not necessarily by the quantum of cleared positions. Further, it demonstrates that there is only limited potential to increase the SITG at a CCP, given that it is a private institution  that must return the equity cost of capital to the market to continue in business. In practice, this restricts the ability to mandate higher SITG for CCPs, for if no private  sector CCP can meet the cost of equity capital, then the clearing solution  needs to be provided by the taxpayer, which is an unacceptable outcome. Finally, this paper calculates the trade-off between increasing SITG and increasing clearing costs to members, to compensate the CCP for returns falling below the equity cost of capital. It establishes that a substantial  increase in SITG over current levels would require  a corresponding  substantial  increase in clearing fees across the financial  sector.