Sunday, May 16, 2021
Home Operations How Central Counterparties Use Default Waterfalls to Manage Systemic Loss

How Central Counterparties Use Default Waterfalls to Manage Systemic Loss

The US Treasury’s Office of Financial Research has released a new working paper that examines how a central counterparty (CCP) uses a default waterfall to manage and allocate resources to cover defaults of clearing members and clients.

A resilient waterfall ensures cleared payments are paid in full and on-time, reducing the threat to financial stability from losses and their spillovers. However, the amount of resources collected and their allocation affect clearing incentives.

The paper, Central Counterparty Default Waterfalls and Systemic Loss, models and evaluates the trade-offs between resiliency and participation in a credit default swaps market, and finds that the benefits of greater central clearing rates generally dominate the benefits of increased waterfall resources.

Abstract

Central counterparty default waterfalls act as last lines of defense in over-the-counter markets by managing and allocating resources to cover defaults of clearing members and clients. However, central counterparties face competing objectives in setting up their default waterfalls. In this paper we evaluate the trade-offs between default waterfall resiliency and central clearing, using a unique and comprehensive dataset containing all U.S. cleared and bilateral credit default swap positions. The paper evaluates the resiliency of different default waterfall designs, accounting for the interconnectedness of payments in the system, the presence of client clearing obligations for members, and the distribution of losses among market participants.

To download the entire report, click here.

- Advertisment -

Most Popular