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November 02, 2017

OFR published a working paper that examines the likelihood that a central counterparty (CCP) will default after a severe credit shock. The paper used credit default swap (CDS) data to estimate the direct and indirect effects of a default by CCP in derivatives trades. The paper concludes that a CCP could be more vulnerable to failure than conventional stress tests have shown.

The paper proposes a general framework for estimating the likelihood of default by central counterparties (CCP) in derivatives markets. Unlike conventional stress testing approaches, which estimate the ability of a CCP to withstand nonpayment by its two largest counterparties, the authors studied the direct and indirect effects of nonpayment by members and/or their clients through the full network of exposures. The authors illustrate the approach for the CDS market under shocks that are similar in magnitude to the FED’s 2015 Comprehensive Capital Analysis and Review trading book shock. The analysis indicates that conventional stress testing approaches may underestimate the potential vulnerability of the main CCP for this market.  

The paper summarizes the protections that the CCP has in place to deal with defaults by its members and examines the way the Depository Trust & Clearing Corporation (DTCC) data is used to derive variation margin payment demands and failure probabilities under the CCAR shock. The paper then analyzes the Cover 2 standard in the context of the CCAR shock. This analysis suggests that the CCP’s default fund is adequate to cover the defaults of its two largest members; however, a different conclusion emerges when network contagion is taken into account. The paper introduces the contagion model, which traces how payment delinquencies by some firms can escalate as they cascade through the network of CDS exposures. The sensitivity of the model to different values for the shock and stress transmission parameters is also demonstrated. Next, the paper describes a probabilistic model that allows the estimation of the probability of a CCP failure relative to the probability of a member’s failure, while making minimal assumptions about the degree of correlation among member failure rates. This model was used to estimate the probability that a CCP would default during a stress of similar magnitude to the CCAR shock. 

 

Related Link: Working Paper (PDF) 

Keywords: Americas, US, Securities, CCP, CCAR, OTC Derivatives, CDS, Stress Testing, Systemic Risk, OFR

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