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To Share or Not to Share? Uncovered Losses in a Derivatives Clearinghouse

Radoslav Raykov

Staff Working Papers from Bank of Canada

Abstract: This paper studies how the allocation of residual losses affects trading and welfare in a central counterparty. I compare loss sharing under two loss-allocation mechanisms – variation margin haircutting and cash calls – and study the privately and socially optimal degree of loss sharing. For losses allocated using variation margin haircuts, I find that trading volume is sensitive to the degree of loss sharing and to the risk sensitivity of skin-in-the-game capital. By contrast, for cash calls, the degree of loss sharing does not affect trading volume but instead affects the chance that a cash call is honoured, which can constrain the recovery of funds. A welfare analysis characterizes the market outcome and compares it with the social optimum.

Keywords: Economic models; Payment clearing and settlement systems (search for similar items in EconPapers)
JEL-codes: G19 G21 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2016
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