Reforms after the financial crisis of 2007-09 promote the use of central counterparties to reduce counterparty risk. The central counterparty, also known as the clearinghouse, enters a trade both as the buyer to the original seller and as the seller to the original buyer. This way, the original counterparties of the trade become insulated from each other's default risk—provided that the clearinghouse meets its own obligation. To ensure its resilience, a clearinghouse collects two types of collateral from clearing members: initial margin and default funds. Despite extensive debate on current clearing practices, there is limited work aimed at understanding the design and regulation of collateral at clearinghouses, and especially on how to determine margins and default fund jointly.

Our recent paper, titled ‘A Theory of Collateral Requirements for Central Counterparties’, provides a novel analytical framework to study the optimal regulation of initial margin and default fund requirements. While posting collateral increases members' pledgeable income and gives them incentives for risk management, different types of collateral have distinct implications for members' risk-shifting incentives and clearinghouse resilience. Striking the right balance between the two, however, is challenging.

Initial margin is more cost-effective in aligning members' incentives. By contrast, default fund is less effective in providing incentives ex-ante because the collateral resources are pooled across members to achieve loss-sharing ex-post. Nonetheless, this loss-mutualization benefit is valuable for the resilience of the central counterparty. Our results show that the ratio of initial margin to default fund contributions matters. The optimal collateral arrangements should depend on the opportunity cost of posting collateral, its effectiveness in providing incentives, and the cost of recapitalizing a clearinghouse.

When the opportunity cost of collateral is the primary concern, the collateral policy should rely more on margins, which are a more cost-effective tool to provide incentives. This happens, for example, in a high-interest-rate environment during economic expansions.

The prediction, however, is very different in an environment of high systemic default risk and low interest rate—like today. With the COVID-19 crisis raging, Ronin Capital, a clearing member of CME and DTCC, defaulted last month. Amid coronavirus-related market volatility, it is not impossible that imploding of multiple members might occur in the coming weeks, imposing a challenge to the stability of the central counterparty. In stressed market scenarios like this when the clearinghouse’s resilience becomes a dominating concern, our model suggests that the collateral policy should rely more on default fund. Indeed, in the first quarter of 2020, major central counterparties largely increased the size of their default funds over the year to end-2019.

Our finding offers a rationale for collecting default funds during periods of market stress. Moreover, the default fund level predicted by our model differs from the current CPSS-IOSCO international regulatory guideline known as the ‘Cover 2’ rule, which requires that the total default fund posted by members should be sufficient to cover the losses caused by the defaults of the two largest clearing members. We show that, for clearinghouses consisting of many members, the total default funds collected should cover the shortfalls of a certain fraction of clearing members and respond to entry and exit of members in the clearing business. This finding is in keeping with legal studies which argue that the ‘Cover 2’ standard is far from prudent.

In addition, our findings provide regulatory guidance on how to encourage clearing participation. First, the clearing mandate should be accompanied by dealers' ability to charge a higher spread for a centrally cleared contract. For this to happen, the counterparty risk needs to be materially reduced in a centrally traded platform, which requires the CCP to collect enough resources to guarantee the transactions. Second, the collateral requirements should be thoughtfully regulated. While providing incentives to encourage risk management is essential, it must be done in a way that accounts for members' opportunity cost of collateral.


Jessie Jiaxu Wang, is an Assistant Professor of Finance at the W. P. Carey School of Business at Arizona State University.

Agostino Capponi, is an Associate Professor of Industrial Engineering and Operations Research at Columbia University.

Hongzhong Zhang, is a Post-Doctoral Research Associate at Columbia University.