Liquidity Risks due to Physical Settlement Affect CCP Resource Demands

Views and opinions expressed are those of the authors and do not necessarily represent official positions or policies of the OFR or Treasury.

Central counterparties (CCPs) have become increasingly important financial market intermediaries. These institutions stand between parties to derivatives, securities, or short-term funding transactions and manage the counterparty credit risk. To do so, they require members and non-member clearing clients to post collateral. The collateral is intended to provide liquid resources to meet interim payment obligations that are missed, as well as to absorb losses arising from defaulted member positions.

In their working paper, “Central Counterparty Management of Liquid and Prefunded Resources,” John Heilbron, independent researcher, and Nicholas Schwartz, OFR Quantitative Analyst, study the CCP’s resource management problem. They model a CCP’s demand for liquid and capital resources in response to key determinants like market volatility, contract turnover, and the extent of loss sharing between clearing members. The authors show how these CCP resources and their determinants vary among large global CCPs.

Required liquid resources differ from prefunded resources, especially at CCPs facilitating physically settled transactions, such as securities trades and repurchase agreements (repo). CCPs obtain these additional liquid resources by requiring clearing members to provide lines of credit to the CCP. This helps divide funding risks associated with counterparty default across its clearing members. In the data, securities and repo CCPs tend to require more liquid resources than, for example, derivatives CCPs, consistent with the demands of physical settlement.