Risk Mutualization in Central Clearing: An Answer to the Cross-Guarantee Phenomenon from the Financial Stability Viewpoint

Abstract

Central counterparties’ (CCPs) role is to take over the counterparty risk during trading. To fulfill its role, a CCP needs to operate a multi-level guarantee system that can absorb losses of clearing members’ defaults. Our main question is how the size of the guarantee system changes and how the cross-guarantee undertaking changes between clearing members and markets if the CCP merges the guarantee systems of different markets. This question is essential from a financial stability perspective since the size and the structure of the guarantee system will affect the loss-absorbing capacity of a CCP. We used Monte Carlo simulation to simulate a 30 year time-series for three different products, which gave us the basis for the value-at-risk-based margin calculation and the stress-test-based default fund calculation. Results show that merging the guarantee systems will always decrease the total value of the guarantees because the margin will decrease, which cannot be offset by the increase in the default fund size. We conclude that it is not optimal from the financial stability perspective to merge the guarantee systems. However, if the CCP wants to provide cheaper services, or if the clearing members are willing to cross-guarantee each other, merging is more suitable.

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“…Third, the stress test methodology suits well the framework of the Internal Capital Adequacy Assessment Process (ICAAP) in the second pillar of banking risk management. Stress test tools have been specifically developed to look at how negative scenarios affect the underlying factors that ensure safe operation and to assess the shock-resilience of institutions, hence their contribution to the systemic risk [ 40 ]. For banks, the classic regulatory and supervisory requirement is to have the right amount of capital to ensure the repayment of liabilities even in a stress event.…”