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Central Counterparty Default Waterfalls and Systemic Loss

Author

Listed:
  • Mark Paddrik

    (Office of Financial Research, U.S. Treas)

  • Simpson Zhang

    (Office of the Comptroller of the Currency)

Abstract

Central counterparties (CCP) make financial markets more resilient through default waterfalls that sequentially manage and allocate resources to cover defaults of clearing members and clients. However, the amount of resources collected and how resources are allocated along the default waterfall can create competing objectives for the CCP. In this paper, we develop a model to measure the resiliency of a default waterfall's design, accounting for the interconnected nature of payment obligations and the distribution of losses among firms. We use a unique and comprehensive dataset containing both bilateral and centrally cleared CDS transactions to address the impact of default waterfall design on a systemic loss. We show that the distribution of segregated and shared resources in the waterfall strongly influences CCP resiliency and the participation incentives of member firms. Our results indicate that real-world CCP waterfall resource allocations and sizes are currently built to limit member losses at the potential expense of greater systemic losses.

Suggested Citation

  • Mark Paddrik & Simpson Zhang, 2019. "Central Counterparty Default Waterfalls and Systemic Loss," 2019 Meeting Papers 213, Society for Economic Dynamics.
    • Handle: RePEc:red:sed019:213
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    Cited by:

    1. Viral V. Acharya & Aaditya M. Iyer & Rangarajan K. Sundaram, 2020. "Risk-Sharing and the Creation of Systemic Risk," JRFM, MDPI, vol. 13(8), pages 1-38, August.
    2. Jin-Wook Chang, 2019. "Collateralized Debt Networks with Lender Default," Finance and Economics Discussion Series 2019-083, Board of Governors of the Federal Reserve System (U.S.).
    3. Berlinger, Edina & Bihary, Zsolt & Dömötör, Barbara, 2024. "Dynamic margin optimization," Finance Research Letters, Elsevier, vol. 68(C).
    4. Mark Paddrik & H. Peyton Young, 2021. "Assessing the Safety of Central Counterparties," Working Papers 21-02, Office of Financial Research, US Department of the Treasury, revised 14 Jul 2021.
    5. Jessie Jiaxu Wang & Agostino Capponi & Hongzhong Zhang, 2022. "A Theory of Collateral Requirements for Central Counterparties," Management Science, INFORMS, vol. 68(9), pages 6993-7017, September.

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