Journal of Financial Market Infrastructures

Risk.net

Procyclicality and risk-based access: valuing the embedded credit default swap of employing bilateral credit limits in financial market infrastructures

Oluwasegun Bewaji

  • Using institutional knowledge of the survivor pay component (Tranche 2) of the Canadian Larger Value Transfer System (LVTS) it is possible to value the credit risk exposure participants in the system incur in the System as a credit default swap (CDS). Similar knowledge of other financial market infrastructures (FMIs) or central counterparties (CCPs) affords the ability to better understand the trade-off between credit risk and liquidity efficiencies of FMI system design.
  • The asset valuation approach to the assessment of the institutional design of FMIs permits FMI operators and regulators insights into understanding the conditions under which participants in FMIs such as the LVTS might find it optimal withdraw from loss sharing frameworks.
  • The results highlight a potential specification of “risk-based access” to clearing and settlement in FMIs.
  • A further policy implication of valuations of the credit risk liquidity risk trade-off is to dampen perceptions of procyclicality in loss sharing arrangements.

In light of institutional knowledge, this paper presents the similarities between the survivor-pay component (Tranche 2) of the Canadian large-value transfer system (LVTS) and credit default swap (CDS) contracts. Accordingly, the default leg of financial market infrastructures (FMIs) or central counterparties (CCPs) is similar to that of a CDS, whereas liquidity efficiencies are mapped to the premium leg. Consequently, this paper conducts a simple numerical approximation of the empirical risk-neutral daily valuation of Tranche 2 from January 2005 to December 2016. In so doing, it identifies conditions under which LVTS participants might withdraw from the loss-sharing framework.  The results highlight a potential specification of risk-based  access to clearing and settlement in FMIs. A further policy implication of valuations of the credit risk–liquidity risk trade-off is the dampening of perceptions of procyclicality in loss-sharing arrangements.

To continue reading...

You need to sign in to use this feature. If you don’t have a Risk.net account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an individual account here: