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

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.