Journal of Financial Market Infrastructures

Risk.net

Central counterparty capital and nondefault losses

Dennis McLaughlin

  • This paper analyses the components of CCP capital requirements and makes two key observations on the potential for loss absorption.  
  • The first observation on default losses appears to be widely understood in the industry: as long as the CCP is not prevented from following the standard loss waterfall in its rulebook, then any losses which arise directly from member defaults can be absorbed with existing CCP resources used together with rulebook powers to allocate any excess losses back to surviving members.  
  • The second observation is a new frequency/severity result on nondefault losses (NDLs). These are losses not directly due to a member default or not covered by the rulebook: the chances that such a loss exceeds regulatory capital actually held is a very rare event (at most two in a thousand). Moreover, the expected shortfall of such an event is an insurable quantum of less than one year’s profit to the healthy CCP. 
     

This paper analyses the components of central counterparty (CCP) capital requirements and makes several observations on the potential for loss absorption. Our first observation on default losses appears to be widely understood in the industry: as long as the CCP is not prevented from following the standard loss waterfall in its rule book, any losses that arise directly from member defaults can be absorbed by using existing CCP resources together with rule book powers to allocate any excess losses back to surviving members. Our second observation is a new frequency/severity result on nondefault losses. These are losses that are not directly due to a member default or are not covered by the rule book: the chance that such a loss exceeds the regulatory capital actually held is a very rare (at most, a two in a thousand) event. Moreover, the expected shortfall of such an event is an insurable quantum of less than one year’s profit to the healthy CCP. In the absence of an empirical database on CCP losses, these observations are ultimately inferred from comparable loss data from the 2008 Bank for International Settlements Loss Data Collection Exercise and from tail loss severity parameters implicit in existing CCP regulatory capital requirements.

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