Working Paper: CEPR ID: DP17679
Authors: John Chifong Kuong; Vincent Maurin
Abstract: This paper analyzes the optimal allocation of losses via a Central Clearing Counterparty (CCP) in the presence of counterparty risk. A CCP can hedge this risk by mutualizing losses among its members. This protection, however, weakens members’ incentives for risk management. Delegating members’ risk monitoring to the CCP alleviates this tension in large markets. To discipline the CCP at minimum cost, members offer the CCP a junior tranche and demand capital contribution. Our results endogenize key layers of the default waterfall and deliver novel predictions on its composition, collateralrequirements, and CCP ownership structure.
Keywords: Collateral; Monitoring
JEL Codes: D86; G23; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| mutualization of losses (G33) | reduced overall risk exposure for members (G52) |
| collateral costs (J32) | efficiency of central clearing (D61) |
| delegating risk monitoring to the CCP (E61) | alleviated tensions between mutualization and individual risk management incentives (G52) |
| CCP holding a junior equity tranche (G19) | aligns its incentives with those of its members (J54) |
| member negotiations (J50) | design of the CCP's capital structure (G32) |
| design of the default waterfall (Q25) | incentives for risk management (G52) |