Welcome to the first issue of Volume 10 of The Journal of Financial Market Infrastructures. This issue contains three papers on central counterparties (CCPs).
In the first paper in the issue, “Central counterparty capital and nondefault losses”, Dennis A. McLaughlin analyses the adequacy of CCPs’ regulatory held capital for nondefault losses. Nondefault losses in the context of the CCP such as investment losses, custodial failures or operational losses – are rarely studied, and this paper is a welcome addition to the academic literature on CCPs. It uses an operational value-atrisk approximation and estimates the necessary parameters using two sources: information from historical tail losses that occurred at banks and a reverse engineering approach of regulatory capital requirements for CCPs. The main result is that for major CCPs in general, a nondefault loss exceeding regulatory capital held is very rare, and if it occurs the expected shortfall would be of the order of up to one year’s profits.
In the issue’s second paper, “Procyclicality of central counterparty margin models: systemic problems need systemic approaches”, Pedro Gurrola Perez tackles a crucial aspect of CCPs in the context of financial stability: the need for an anti-procyclicalrisk policy for each CCP, but also more broadly for the entire global financial system. It is well known from the literature that anti-procyclicality for CCPs is a balancing act: margin should react to shocks in the financial system to cover the CCP, and hence all clearing members, at all times, but it should also be calibrated such that margin moves are small enough not to exacerbate collateral and liquidity pressures for the clearing members and their clients. The author provides a rich and deep study of anti-procyclical strategies and applies his findings to a recent case – the March 2020 Covid events – to assess their performance. In addition, he emphasizes the need to consider anti-procyclicality at the systemic level.
In our third and final paper, “The customer settlement risk externality at US securities central counterparties”, we see Sam Schulhofer-Wohl taking the client perspective (here the buyer or seller of securities via the clearing member). Given the two days between securities trading and settlement (T C 2), the (pre-)settlement risk created by the client’s behavior causes an externality for clearing members, as the former does not always pay the full cost of the latter managing that risk. A case in point is the GameStop event of January 2021. The author examines the sources of the externality and discusses the potential benefits and costs of separating client positions from member positions. He also concludes that shortening the settlement period to T C 1 would mitigate settlement risk somewhat but it would not eliminate the externality.
I hope you enjoy reading this issue of The Journal of Financial Market Infrastructures.
This paper analyses the components of central counterparty (CCP) capital requirements and makes several observations on the potential for loss absorption.
In this paper the author argues that the focus on initial margin models is misplaced, and the reasons for this are illustrated by empirically testing the performance of standard initial margin models during the March 2020 events.
This paper highlights an externality in the clearing of customer securities trades, and it examines the potential benefits and costs of alternative clearing approaches.