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The Goldilocks Problem: How to get Incentives and Default Waterfalls “Just Right”

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  • Rebecca Lewis
  • John McPartland

Abstract

Regulatory reforms in the wake of the 2007?08 financial crisis have increased the focus on the systemic importance of central counterparties (CCPs), which guarantee the performance of their clearing members? financial contracts.1 This, in turn, has increased policymakers? and practitioners? focus on risk management at CCPs. A key component of any CCP?s risk-management strategy is the CCP?s default waterfall. The default waterfall stipulates the sequence of financial resources that a CCP can draw upon to cover the unsatisfied financial obligations of a defaulted clearing member. At the top of the waterfall are the margin and default fund contributions of the defaulting clearing member.The remainder of the waterfall comprises contributions from the CCP, known as skin-in-the-game, and contributions from clearing members. This article describes how the structure for these CCP- and member-funded tranches affects how the interests of CCPs, clearing members, and their prudential regulators are aligned.

Suggested Citation

  • Rebecca Lewis & John McPartland, 2017. "The Goldilocks Problem: How to get Incentives and Default Waterfalls “Just Right”," Economic Perspectives, Federal Reserve Bank of Chicago, issue 1, pages 1-13.
  • Handle: RePEc:fip:fedhep:00023
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