The Bank of England has released two papers on CCPs, which explain loss-allocation rules, and how to balance the costs of default resources with the expected losses.
Paper 19, titled: “Central counterparties and their financial resources—a numerical approach”, maintains that new regulatory standards have required central counterparties to have robust processes in place to mitigate their counterparty credit risk exposures.
“At the same time, the standards allow CCPs to tailor their risk management models. This paper considers how CCPs can optimally determine the relative mix of initial margin and default fund contributions in a stylised setting, by balancing the costs of default resources with the expected losses they protect against,” it said.
Where members are of good credit quality and the probability of experiencing losses is low, the loss-mutualising properties of the default fund are favoured over the defaulter-pays properties of initial margin. Significant tail risks in the markets cleared by the CCP further favour the use of the default fund as a cost-effective insurance against potentially large losses.
By contrast, when members are more likely to default or extreme losses are unlikely, the CCP has incentives to maximise the defaulter-pays collateral it takes, and the benefits of the loss-mutualising default fund are reduced, it added.
“Our numerical results support the recognition that CCPs should have some discretion over how they set the optimal level and composition of their default resources, based on the specific risks of the markets and portfolios that they clear.”
The results also show that changes in collateral costs and capital requirements can have a significant impact on a CCP’s optimal risk management choices.
Paper 20, titled: “Central counterparty loss-allocation rules”, states that the insolvency of a CCP could be highly disruptive to the financial system if losses fall on participants in an uncertain and disorderly manner. In contrast to most other financial firms, CCPs’ obligations to their members, and vice versa, are governed by a central rulebook.
“CCPs have the ability to include in this rulebook rules setting out how losses exceeding the CCP’s pre-funded default resources are to be allocated between participants. Indeed, some CCPs have already done so. We term such rules ‘loss-allocation rules’.”
These could have the advantages, relative to the counterfactual of the disorderly insolvency of the CCP, of offering transparency and predictability to participants; providing for a quick and orderly allocation of losses; and potentially allowing the CCP to continue to provide critical services to the market, added the paper.
“The detailed design of such rules has important implications for financial stability, as well as for the CCP and its stakeholders. Given these considerations, there is ongoing international work on the design of loss-allocation rules.”
Image: Shutterstock 