Journal of Financial Market Infrastructures
ISSN:
2049-5412 (online)
Editor-in-chief: Manmohan Singh
Need to know
- We introduce an incentive compatibility framework to analyze agency problems linked to CCP risk management. The framework is used to design the capital contribution of a CCP to its default waterfall, known as “CCP skin-in-the-game” (SITG).
- We show that under inadequate SITG levels, non-defaulting members are more exposed to default losses than CCPs. The resulting risk management incentive distortions could be mitigated via our framework.
- Our analysis addresses investor- and member-owned CCPs. We also analyze multilayered and monolayer default waterfalls. The broader central clearing mandate of U.S. Treasuries may take place under monolayer CCPs.
- Viewing the total size of SITG as the lower bound on CCP regulatory capital, the framework can be used to improve capital regulation of investor- and member-owned CCPs. We demonstrate that bank capital rules for CCP exposures may underestimate risk.
Abstract
We introduce a quantitative framework to design the capital contribution of a central counterparty (CCP) to its default waterfall, known as CCP “skin in the game” (SITG). We show that, under inadequate SITG levels, nondefaulting members are more exposed to default losses than CCPs. The resulting risk management incentive distortions could be mitigated by using the proposed framework. Our analysis addresses investor- and member-owned CCPs; we also analyze multilayer and “monolayer” default waterfalls. The broader central clearing mandate of US Treasuries may take place under monolayer CCPs. Viewing the total size of SITG as the lower bound on CCP regulatory capital, the framework can be used to improve capital regulation of investor-and member-owned CCPs. We also show that bank capital rules for CCP exposures may underestimate risk.
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