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To Share or Not to Share? Uncovered Losses in a Derivatives Clearinghouse

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  • Radoslav Raykov

Abstract

This paper studies how the allocation of residual losses affects trading and welfare in a central counterparty. I compare loss sharing under two loss-allocation mechanisms – variation margin haircutting and cash calls – and study the privately and socially optimal degree of loss sharing. For losses allocated using variation margin haircuts, I find that trading volume is sensitive to the degree of loss sharing and to the risk sensitivity of skin-in-the-game capital. By contrast, for cash calls, the degree of loss sharing does not affect trading volume but instead affects the chance that a cash call is honoured, which can constrain the recovery of funds. A welfare analysis characterizes the market outcome and compares it with the social optimum.

Suggested Citation

  • Radoslav Raykov, 2016. "To Share or Not to Share? Uncovered Losses in a Derivatives Clearinghouse," Staff Working Papers 16-4, Bank of Canada.
    • Handle: RePEc:bca:bocawp:16-4
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    References listed on IDEAS

    as
    1. Elliott, David, 2013. "Financial Stability Paper No 20: Central counterparty loss-allocation rules," Bank of England Financial Stability Papers 20, Bank of England.
    2. Philipp Haene & Andy Sturm, 2009. "Optimal Central Counterparty Risk Management," Working Papers 2009-07, Swiss National Bank.
    3. Markus K. Brunnermeier & Lasse Heje Pedersen, 2009. "Market Liquidity and Funding Liquidity," The Review of Financial Studies, Society for Financial Studies, vol. 22(6), pages 2201-2238, June.
    4. Alma Cohen & Liran Einav, 2007. "Estimating Risk Preferences from Deductible Choice," American Economic Review, American Economic Association, vol. 97(3), pages 745-788, June.
    5. Siyi Zhu, 2011. "Is there a 'race to the bottom' in central counterparties competition?," DNB Occasional Studies 906, Netherlands Central Bank, Research Department.
    6. Alexandra Heath & Gerard Kelly & Mark Manning, 2015. "Central Counterparty Loss Allocation and Transmission of Financial Stress," RBA Research Discussion Papers rdp2015-02, Reserve Bank of Australia.
    7. Thorsten V. Koeppl, 2013. "The Limits Of Central Counterparty Clearing: Collusive Moral Hazard And Market Liquidity," Working Paper 1312, Economics Department, Queen's University.
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    Cited by:

    1. Lannoo, Karel, 2017. "Derivatives Clearing and Brexit: A comment on the proposed EMIR revisions," ECMI Papers 13150, Centre for European Policy Studies.

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    More about this item

    Keywords

    Economic models; Payment clearing and settlement systems;

    JEL classification:

    • G19 - Financial Economics - - General Financial Markets - - - Other
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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