CDS Central Counterparty Clearing Default Measures: Road to Recovery or Invitation to Predation?

Magdalena Tywoniuk
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Magdalena Tywoniuk: Swiss Finance Institute, Students; University of Geneva - Geneva Finance Research Institute (GFRI); Swiss Finance Institute, Students

No 20-95, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: Following the 2008 financial crisis, regulation mandates the clearing of the CDS market through Central Clearing Counter-parties (CCPs). Large CCPs are now designated as ’Global Systemically Important Institutions’ (GSIIs), whose unlikely-but-plausible failure threatens global financial market stability. This work examines CCP resilience following a large dealer member’s default and the ensuing default contagion. In unwinding the defaulter’s positions, the CCP faces the price impact of constrained member liquidations and unconstrained members’ predatory selling. The variation margin captures the effect of price-mediated contagion and its amplification. A novel spatial measure captures the covariance between members’ CDS holdings and the CDS being unwound. Key results show: Liquidations by constrained members lower the CCP’s profits and make cds-spreads less informative. There exists a strong conflict between predatory competition and dealer distress, which inadvertently makes dealers prey on themselves. In turn, the adoption of a risk-sharing guarantee fund structure would provide a natural disciplinary mechanism for predation – minimizing overall CCP and member losses. A dynamic simulation, calibrated to OTC market data, supports these theoretical results with parameter magnitudes and sensitivities. Examination of three market liquidity scenarios provides intuition for effective liquidity injection by a Lender of Last Resort.

Keywords: Systemic Risk; CCP Recovery; CDS; CDS Spread Fire Sales; Liquidation; Predation; Price Impact; Contagion; Financial Network; Over the Counter Markets (search for similar items in EconPapers)
JEL-codes: G00 G01 G02 G10 G14 G18 G20 G23 G33 (search for similar items in EconPapers)
Pages: 75 pages
Date: 2020-11
New Economics Papers: this item is included in nep-fmk and nep-rmg
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2095

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