Model risk at central counterparties: Is skin-in-the-game a game changer?

Focus

We investigate how central counterparties (CCPs) manage counterparty credit risks. CCPs play a key role in clearing derivative trades. They stand between clearing members, insuring them against counterparty credit risks. To manage these risks, CCPs ask their clearing members for collateral, ie initial margin. Model risk arises when a CCP underestimates potential credit losses in its initial margin model. If model risk were to materialise at a time of stress, it could lead to the CCP's failure - with systemic consequences.

Contribution

Our contribution is to examine how CCPs might be incentivised to set the initial margin correctly. Incentives matter, because setting the initial margin requires CCPs to make expert judgments. Other parties, such as regulators, lack the information to set them efficiently. We examine three factors that might influence incentives: (i) skin-in-the-game, ie a CCP's own capital, which can be used to cover credit losses; (ii) profits as a proxy for franchise value; and (iii) capital other than skin-in-the-game. We ask how these variables relate to five proxies for model risk: (1) number of margin breaches; (2) achieved coverage; (3) difference between achieved and target coverage; (4) average size of margin breaches; and (5) maximum size of margin breaches.

Findings

We find that a higher amount of skin-in-the-game is associated with a lower degree of model risk. We do not find any similar association between model risk and profits or capital other than skin-in-the-game. The results are robust for all five proxies of model risk.

Abstract

We investigate empirically how the balance sheet characteristics of central counterparties (CCPs) affect their modelling of credit risk. CCPs set initial margin (IM), i.e., the collateral for transactions, to limit counterparty credit risk. When a CCP's IM model fails on a large scale, the CCP could fail too, losing its skin-in-the-game capital. We find that higher skin-in-the-game is significantly associated with more p rudent modelling, in contrast to profits (a proxy for franchise value) and forms of capital other than skin-in-the-game. The results may help to inform the ongoing policy debate on how to incentivise prudent credit risk management at CCPs.

JEL classification: F34, F42, G21, G38

Keywords: central counterparties (CCPs), capital, risk-taking