Market liquidity, closeout procedures and initial margin for CCPs

Fernando V. Cerezetti, Emmanouil N. Karimalis, Ujwal Shreyas and Anannit Sumawong

The European Journal of Finance, 2019, vol. 25, issue 7, 599-631

Abstract: Closeout procedures enable central counterparties (CCPs) to respond to events that challenge the continuity of their normal operations, most frequently triggered by the default of one or more clearing members. The procedures typically entail three main phases: splitting, hedging, and liquidation. Together, these ensure the regularity of the settlement process through the prudent and orderly liquidation of the defaulters’ portfolios. Traditional approaches to CCPs’ margin requirements typically assume a simple closeout profile, not accounting for the ‘real life’ constraints embedded in the management of a default. The paper proposes an approach to assess how distinct closeout strategies may expose a CCP to different sets of risks and costs taking into account real-life frictions. The proposed approach enables the evaluation of a full spectrum of hedging strategies and the assessment of the trade-offs between the risk-reducing benefits of hedging and the transaction costs associated with it. Using an unexplored set of transactional level data, the proposed framework is evaluated assuming the hypothetical default of a real CCP clearing member. We consider the worst-case loss of a large interest rate swap portfolio observed over the past 10 years (i.e. 2005–2015) and show that an efficient hedging strategy which minimises risk may not be optimal when transaction costs are taken into account. The empirical analysis suggests that transaction costs are a significant factor and should be accounted for when designing a hedging strategy. Specifically, it is shown that the risk-reducing benefits arising from more tailored hedging strategies may introduce higher transaction costs, and therefore may change the effectiveness of the strategies.

Date: 2019
References: Add references at CitEc
Citations: View citations in EconPapers (5)

Downloads: (external link)
http://hdl.handle.net/10.1080/1351847X.2018.1496944 (text/html)
Access to full text is restricted to subscribers.

Related works:
Working Paper: Market liquidity, closeout procedures and initial margin for CCPs (2017)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:taf:eurjfi:v:25:y:2019:i:7:p:599-631

Ordering information: This journal article can be ordered from
http://www.tandfonline.com/pricing/journal/REJF20

DOI: 10.1080/1351847X.2018.1496944

Access Statistics for this article

The European Journal of Finance is currently edited by Chris Adcock

More articles in The European Journal of Finance from Taylor & Francis Journals
Bibliographic data for series maintained by Chris Longhurst ().