Together Forever or Separated for Life

Abstract

The role of the central counterparties on the market is to take over the counterparty risk during the trading on stock exchanges. To fulfill its role, a CCP needs to maintain financial resources that can absorb losses in case of the default of a clearing member. A default waterfall system is operated by CCPs, one of which element is the default fund (DF) contribution by members. Our paper focuses on the default fund design a central counterparty (CCP) operates and the stress test applied to quantify the size of it. There is always a trade-off between the margin requirements and the default fund regarding risk-sharing and their sizes. Two possible designs are presented, therefore, our paper analyzes the default funds, and the cross-guarantee between CMs, from the viewpoint of having a joint or separated default fund for different markets. In the risk management system of several CCPs the size of the default fund is linked to the result of the stress tests. Applying stress on the proposed model, results show that from the market participants’ perspective that are present only on the spot market a merged market is not in their favour, while for those, who are present on both markets benefit from the merged markets. From the CCPs point of view, on one hand the most prudent step to take is to clear the markets separately, since the overall value of the guarantees would be higher in this case, but on the other hand from competition point of view, the lower margin and default fund values can strengthen a CCPs position in acquiring and keeping clearing members.