The key protection which CCPs have against counterparty credit risk is their default waterfall. They take margin from clearing members and imagestheir clients, and default fund contributions from clearing members, and use these amounts as a bulwark against losses should a clearing member default.

The different levels in the default waterfall – margin, CCP equity, default fund, default fund assessment rights, and so on – are accessed in sequence, much like the tranches of a CDO. Typically the defaulter’s margin and default fund are used first, then an amount of CCP equity is at risk, then the mutual default is used, and typically more default fund can then be called from surviving members. That is, the default waterfall starts off individual, with the defaulter (or rather their estate) paying, and then becomes mutual. 

A question that immediately arises here is whether this pattern is necessary. After all, it could be argued that making clearing members who have never dealt with the defaulter pay is unfair. Perhaps there should be an incentive for performing counterparty due diligence, whereby a clearing member’s default fund is only at risk to the extent that they brought ‘bad risk’ or ‘bad counterparties’ to the CCP?

This idea is not new; the US bond CCP the Fixed Income Clearing Corporation has had a default waterfall which incorporates this idea. But it does suggest that individual-then-fully-mutual pattern is not the only way to arrange a clearing houses’ waterfall. It may not even be the best way, even ignoring incentive structures. This is clear if we consider CCPs with heterogeneous membership. If a CCP has a low membership bar and full mutuality, then better quality firms may be discouraged from becoming clearing members, as they will in effect have to underwrite their competitors’ poor credit quality. Relaxing mutuality in the default fund would make such a CCP more attractive to high quality clearing members.

The EMIR and Dodd Frank deadlines have required OTC derivatives CCPs to set up or to extend their cleared product range quickly. Hence it is no surprise that they have mostly followed a familiar pattern. Now that we are moving towards a more mature phase however, there may be scope for second generation CCPs to appear with more innovative structures. Sophisticated default waterfalls, incorporating features such as ‘those who dealt with the defaulter pay next’, or tiered membership, may well appear.

David’s new book, OTC Derivatives, Bilateral Trading and Central Clearing: An Introduction to Regulatory Policy, Market Impact and Systemic Risk appeared from Palgrave Macmillan in the UK on the 7th August, and will appear in the US shortly. This volume provides a comprehensive introduction to the bilateral OTC markets, the post-crisis regulatory reforms, and the new centrally cleared post-trade environment. The post above is based on a part of chapter 9 where David and his co-author, Edwin Budding, discuss choices in the design of CCPs. I am in search of the book.