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Central counterparty capitalization and misaligned incentives

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  • Wenqian Huang

Abstract

Financial stability depends on the effective regulation of central counterparties (CCPs), which must take account of the incentives that drive CCP behavior. This paper studies the incentives of a for-profit CCP with limited liability. It faces a trade-off between fee income and counterparty credit risk. A better-capitalized CCP sets a higher collateral requirement to reduce potential default losses, even though it forgoes fee income by deterring potential traders. I show empirically that a 1% increase in CCP capital is associated with a 0.6% increase in required collateral. Limited liability, however, creates a wedge between its capital and collateral policy and the socially optimal solution to this trade-off. The optimal capital requirements should account for clearing fees.

Suggested Citation

  • Wenqian Huang, 2019. "Central counterparty capitalization and misaligned incentives," BIS Working Papers 767, Bank for International Settlements.
  • Handle: RePEc:bis:biswps:767
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    References listed on IDEAS

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    1. Boissel, Charles & Derrien, François & Ors, Evren & Thesmar, David, 2017. "Systemic risk in clearing houses: Evidence from the European repo market," Journal of Financial Economics, Elsevier, vol. 125(3), pages 511-536.
    2. Bignon, Vincent & Vuillemey, Guillaume, 2016. "The Failure of a Clearinghouse: Empirical Evidence," CEPR Discussion Papers 11630, C.E.P.R. Discussion Papers.
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    Cited by:

    1. Mark Paddrik & Simpson Zhang, 2020. "Central Counterparty Default Waterfalls and Systemic Loss," Working Papers 20-04, Office of Financial Research, US Department of the Treasury.
    2. Kubitza, Christian & Pelizzon, Loriana & Getmansky, Mila, 2018. "The pitfalls of central clearing in the presence of systematic risk," ICIR Working Paper Series 31/18, Goethe University Frankfurt, International Center for Insurance Regulation (ICIR).
    3. Jorge Cruz Lopez & Mark Manning, 2017. "Who Pays? CCP Resource Provision in the Post-Pittsburgh World," Discussion Papers 17-17, Bank of Canada.
    4. Bank for International Settlements, 2019. "Establishing viable capital markets," CGFS Papers, Bank for International Settlements, number 62, September.

    More about this item

    Keywords

    central counterparties (CCPs); capital requirement; financial stability;

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies

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