February 11, 2019

BIS published a working paper that studies the incentives of a for-profit central counterparties (CCP) with limited liability. A CCP faces a trade-off between fee income and counterparty credit risk. The paper investigates whether such CCP incentives undermine financial stability.

Such for-profit CCPs choose how much capital to hold and set the collateral requirement for their clearing members, to maximize their own profits. They face a trade-off between fee income and counterparty credit risk. However, the limited liability of a CCP creates a misalignment between its choices and the socially optimal solution to this trade-off. In studying the factors that give rise to this misalignment, the paper derives the optimal capital regulations and examines the significant role of CCP ownership structures in safeguarding financial stability. This is the first paper that argues that a for-profit CCP would seek to hold less capital than is optimal from a social welfare perspective and, similarly, would require less collateral from its members than is optimal, thus undermining financial stability. From an empirical angle, this paper also provides the first evidence of a relationship between the capital held by CCPs and the collateral they require.

The model developed in this paper implies that better-capitalized CCPs set higher collateral requirements. Empirical evidence suggests that a 1% increase in a for-profit CCP's capital is associated with a 0.6% increase in its members' collateral. Another implication, again deriving from its capitalization and collateral choices, is that a for-profit CCP is more likely to fail than is socially optimal. By contrast, a user-owned CCP chooses to hold more capital and is, therefore, less likely to fail. The data show that user-owned CCPs hold significantly more capital, on average, than for-profit CCPs do. Optimal capital requirements are derived for different levels of the clearing fees charged by for-profit CCPs. When this fee is low, the capital requirements incentivize CCPs to demand more collateral, thus bolstering financial stability. When fees are high, capital requirements do not change a CCP's incentives but serve to boost its loss-absorbing capacity.

 

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Keywords: International, PMI, Banking, Securities, CCPs, Financial Stability, Capital Requirements, BIS

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