Central Counterparty Loss Allocation and Transmission of Financial Stress

Alexandra Heath, Gerard Kelly and Mark Manning
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Alexandra Heath: Reserve Bank of Australia
Gerard Kelly: Reserve Bank of Australia
Mark Manning: Reserve Bank of Australia

RBA Research Discussion Papers from Reserve Bank of Australia

Abstract: Among the reforms to over-the-counter (OTC) derivative markets since the global financial crisis is a commitment to collateralise counterparty exposures and to clear standardised contracts via central counterparties (CCPs). The reforms aim to reduce interconnectedness and improve counterparty risk management in these important markets. At the same time, however, the reforms necessarily concentrate risk in one or a few CCPs and also increase institutions' demand for high-quality assets to meet collateral requirements. This paper looks more closely at the implications of these reforms for the stability of the financial network. Following Heath, Kelly and Manning (2013), the paper examines liquidity and solvency risk under alternative clearing configurations, but extends the analysis in two main ways. First, rather than using simulated data, it uses actual data on the derivative positions of the 41 largest bank participants in global OTC derivative markets in 2012 (as previously used by the Bank for International Settlements' Macroeconomic Assessment Group on Derivatives). Second, it extends the methodolgy to consider in greater depth the implications of loss allocation by CCPs to meet obligations once pre-funded financial resources have been exhausted, and in particular the mechanism of variation margin gains haircutting. This mechanism is considered in international standard-setters' guidance on recovery planning for CCPs and has been adopted by some CCPs. The paper demonstrates that designing and operating CCPs in accordance with international standards can limit the potential for stress to propagate through the system, even in very extreme market conditions.

Keywords: clearing; netting; financial stability; central counterparty; derivatives; loss allocation; recovery and resolution (search for similar items in EconPapers)
JEL-codes: E42 G17 G23 (search for similar items in EconPapers)
Date: 2015-03
New Economics Papers: this item is included in nep-rmg
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Citations: View citations in EconPapers (10)

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