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Practice paper

The end of the waterfall: Default resources of central counterparties

Rama Cont
Journal of Risk Management in Financial Institutions, 8 (4), 365-389 (2015)
https://doi.org/10.69554/JZQP9267

Abstract

Central counterparties (CCPs) have become pillars of the new global financial architecture following the financial crisis of 2008. The key role of CCPs in mitigating counterparty risk and contagion has in turn cast them as systemically important financial institutions whose eventual failure may lead to potentially serious consequences for financial stability, and prompted discussions on CCP risk management standards and safeguards for recovery and resolutions of CCPs in case of failure. We contribute to the debate on CCP default resources by focusing on the incentives generated by the CCP loss allocation rules for the CCP and its members and discussing how the design of loss allocation rules may be used to align these incentives in favour of outcomes which benefit financial stability. After reviewing the ingredients of the CCP loss waterfall and various proposals for loss recovery provisions for CCPs, we examine the risk management incentives created by different ingredients in the loss waterfall and discuss possible approaches for validating the design of the waterfall. We emphasise the importance of CCP stress tests and argue that such stress tests need to account for the interconnectedness of CCPs through common members and cross-margin agreements. A key proposal is that capital charges on assets held against CCP default funds should depend on the quality of the risk management of the CCP, as assessed through independent stress tests.

Keywords: CCP; central clearing; central counterparty; systemic risk; default risk; counterparty risk,; default fund; OTC derivatives; mechanism design; regulation; EMIR

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Author's Biography

Rama Cont is a professor at Imperial College London, where he is Chair in Mathematical Finance, and Director of the CFM-Imperial Institute of Quantitative Finance. He has previously taught at Columbia University (New York), Ecole Polytechnique (France) and Université Pierre & Marie Curie (Paris), and has served as consultant to numerous financial institutions, CCPs and regulatory organisations in the United States, Europe, Asia and Latin America.

Citation

Cont, Rama (2015, October 1). The end of the waterfall: Default resources of central counterparties. In the Journal of Risk Management in Financial Institutions, Volume 8, Issue 4. https://doi.org/10.69554/JZQP9267.

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cover image, Journal of Risk Management in Financial Institutions
Journal of Risk Management in Financial Institutions
Volume 8 / Issue 4
© Henry Stewart
Publications LLP

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