Journal of Financial Market Infrastructures

Central counterparty auction design

Gerardo Ferrara, Xin Li and Daniel Marszalec

  • Inefficient auction mechanisms could pose a risk to financial stability
  • An auction design with penalty mechanism (eg, juniorization process) could increase the probability that the penalized clearing members will not be able to meet their own future obligations
  • A second-price auction with loss-sharing incentivizes competitive bidding by giving bidders a target-price above which they will be exempt from a possible penalty; this results in a higher revenue for the CCP

We analyze the role of auctions in managing the default of a central counterparty's clearing member. We first consider two established sealed-bid auction formats in which clearing members simultaneously submit bids for a defaulting clearing member's portfolio: first price and first price with budget constraints. We argue that the use of some form of penalty could have significant implications for financial stability by inefficiently distributing losses deriving from the unallocated portfolio to surviving clearing members. In response to these potential adverse implications, we propose a third auction type, second price with loss-sharing, which increases the revenue by allowing bidders to consider potential losses within their bidding function without passively waiting for a possible form of penalty.

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