Research on Clearing

Presentation to MRAC, June 20, 2017

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* This presentation reflects the opinions of its authors only, and not those of the Commodity Futures Trading Commission (CFTC), any of its 

Commissioners or the Federal Reserve Bank of Chicago. 
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Which world model do we live in?
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Which world model do we live in?

Thinking about taxes

Laffer curve

revenue

revenuerevenue

0% tax rate 100% 0% tax rate 100% 0% tax rate 100% 

• Shape depends on # of variables in the model

• Choices involve trade offs

• “Where you want to go depends on where you are”
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Which world model do we live in?

Thinking about CCPs – Skin in the Game maybe? What is an objective measure of resilience?

? 

• What percent of what?

• Senior, mezzanine, junior?

• Where in the water-fall?

• How about CCP and CM incentives 

conditional on regulations?

Where am I today?

What are the trade-offs?
Overview

 Recent regulation, led by the G20 mandates, have placed an emphasis on 

central clearing

 A growing amount of academic literature has focused on the place of clearing 

within the derivatives ecosystem, including the effects on:

 Risk management and risk distribution

 Relative incentives of different market actors 

 Potential loss distributions and contagion after a market default

 Key to this literature is the differing incentives across clearing actors

 Multiple participant groups: clearinghouses, clearing firms, clearing customers

 We will focus on a few topics with clear trade-offs in policy choices

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The push has resulted in higher clearing levels

6 Source: Bank of International Settlements
Clearing can reduce risks, but also transforms risks

 A move to clearing for standardized products (as recommended by the G20) 

can provide

 Higher level of risk management standardization

 Higher risk transparency (market + regulators)

 Potential increase in the ease of contract netting

 Reduction in independent counterparty credit risk 

 CCPs can reduce counterparty risks, but can also increase liquidity demands 

(Marshall + Steigerwald)

 “Conservation” of risk – credit risk transformed into liquidity (and operational) risk

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The benefits of centralization are dependent on market 

structure

 Legal structure vs counterparty:

 Bilateral markets provide more flexible contractual arrangements, though with a 

smaller set of potential counterparties

 Centralized markets provide standardized product set with wide set of participants

 A number of papers have compared collateral demands in the cleared vs 

uncleared space

 Theoretical papers – Duffie/Zhu, Cont/Kokholm; relative demand dependent on 

market structure - a fragmented CCP ecosystem could increase collateral demand 

due to the lack of netting across products

 Empirical – Duffie et al consider data from the CDS market and find lower collateral 

demand for cleared trades; benefits are largest for those with large, well-diversified 

portfolios 

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Clearing incentives can adjust relative to circumstances

 Default preparation

 Mutualized vs unmutualized risk: defaulter pay (first line of defense) vs survivor pay 

(additional resources) 

 Skin-in-the-game provides additional protection by third participant category (CCP)

 Low rate environment can correlate with higher margin requirements – Capponi et al

 Heterogeneity across members and customers may lead to higher initial margins 

(Capponi) 

 During default

 The goal is to return to a matched-book 

 Returning to a matched book will likely require potentially significant loss allocation

 Loss allocation rules are pre-specified, but ex ante impossible to know how it will 

affect individual clearing actors

 Loss allocation is distinct from returning to a matched book

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Possible Collateral “Worlds”

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Increasing Market 

Stability 

Increasing Funding Cost

High Initial Margin

Low Initial Margin

Untenable

Source: Capponi et al – Clearinghouse Margin Requirements
End of the waterfall

 Variation margin gains haircutting

 Similar to bankruptcy rules – haircut to “bondholders”/those with positive value of 

assets (Cont, Duffie) 

 Unlike bankruptcy rules, impossible to anticipate who will be on the “winning” side of 

positions at the time of default

 How should contract values be set to determine haircut? (Elliott)

 Initial margin haircutting (Duffie, Elliott)

 Losses are proportional to the risk held at the CCP

 Initial margin is not under the ownership of the CCP, so legally difficult, and funds must 

be replaced

 Incentivizes clearing firms to keep initial margin levels low

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Procyclicality 

 Margin requirements (both initial and variation) can be positively correlated 

with market volatility/stress

 Potential mitigants

 Countercyclical charges

 Higher back-testing weighting on stressed periods

 Longer look-back periods

 Too high: Can be destabilizing during periods of stress – large initial and 

variation margin calls (Murphy)

 Too low: Can be unduly expensive during low volatility periods, disincentivizing

clearing (Glasserman and Wu)
Sample margins from four models

13 Source: Murphy et al – Investigation into Procyclicality
Conclusion

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 Recent policy efforts have pushed for a larger role of clearinghouses in 

financial market infrastructure

 The push has led to questions about risk management and risk incentives

 Aim to balance interests of CCPs, members and clients

 Inherent to these efforts is taking account of the policy trade-offs

 Some of these trade-offs are clear ex ante (and have been discussed) – others may 

evolve within the stages of resolution/recovery

 Many trade-offs depend on where we currently stand today