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Contagion in Derivatives Markets

Author

Listed:
  • Mark Paddrik

    (Office of Financial Research, U.S. Department of the Treasury, Washington, District of Columbia 20220)

  • Sriram Rajan

    (Office of Financial Research, U.S. Department of the Treasury, Washington, District of Columbia 20220)

  • H. Peyton Young

    (Office of Financial Research, U.S. Department of the Treasury, Washington, District of Columbia 20220; London School of Economics, London AC2A 2AE, United Kingdom; Nuffield College, Oxford OX1 1NF, United Kingdom)

Abstract

A major credit shock can induce large intraday variation margin payments between counterparties in derivatives markets, which may force some participants to default on their payments. These payment shortfalls become amplified as they cascade through the network of exposures. Using detailed Depository Trust & Clearing Corporation data, we model the full network of exposures, shock-induced payments, initial margin collected, and liquidity buffers for about 900 firms operating in the U.S. credit default swaps market. We estimate the total amount of contagion, the marginal contribution of each firm to contagion, and the number of defaulting firms for a systemic shock to credit spreads. A novel feature of the model is that it allows for a range of behavioral responses to balance sheet stress, including delayed or partial payments. The model provides a framework for analyzing the relative effectiveness of different policy options, such as increasing margin requirements or mandating greater liquidity reserves.

Suggested Citation

  • Mark Paddrik & Sriram Rajan & H. Peyton Young, 2020. "Contagion in Derivatives Markets," Management Science, INFORMS, vol. 66(8), pages 3603-3616, August.
    • Handle: RePEc:inm:ormnsc:v:66:y:2020:i:8:p:3603-3616
    DOI: 10.1287/mnsc.2019.3354
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    Cited by:

    1. Paddrick, Mark & Young, H. Peyton, 2021. "How safe are central counterparties in credit default swap markets?," LSE Research Online Documents on Economics 101170, London School of Economics and Political Science, LSE Library.
    2. Antonio Díaz & Francisco Jareño & Eliseo Navarro, 2022. "Yield curve data choice and potential moral hazard: An empirical exercise on pricing callable bonds," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 27(2), pages 2124-2145, April.
    3. Ghio, Maddalena & Rousová, Linda & Salakhova, Dilyara & Bauer, Germán Villegas, 2023. "Derivative margin calls: a new driver of MMF flows," Working Paper Series 2800, European Central Bank.
    4. Berndsen, Ron, 2020. "Five Fundamental Questions on Central Counterparties," Other publications TiSEM 1f3bd844-92ab-4104-8f57-9, Tilburg University, School of Economics and Management.
    5. Shi, Qing & Sun, Xiaoqi & Jiang, Yile, 2022. "Concentrated commonalities and systemic risk in China's banking system: A contagion network approach," International Review of Financial Analysis, Elsevier, vol. 83(C).
    6. Mark Paddrik & H. Peyton Young, 2021. "Assessing the Safety of Central Counterparties," Working Papers 21-02, Office of Financial Research, US Department of the Treasury.
    7. Bardoscia, Marco & Ferrara, Gerardo & Vause, Nicholas & Yoganayagam, Michael, 2021. "Simulating liquidity stress in the derivatives market," Journal of Economic Dynamics and Control, Elsevier, vol. 133(C).
    8. Walter Farkas & Patrick Lucescu, 2024. "Modeling Risk Sharing and Impact on Systemic Risk," Mathematics, MDPI, vol. 12(13), pages 1-19, July.
    9. Jessie Jiaxu Wang & Agostino Capponi & Hongzhong Zhang, 2022. "A Theory of Collateral Requirements for Central Counterparties," Management Science, INFORMS, vol. 68(9), pages 6993-7017, September.
    10. H Peyton Young & Mark Paddrik, 2019. "How Safe are Central Counterparties in Credit Default Swap Markets?," Economics Series Working Papers 885, University of Oxford, Department of Economics.
    11. Inaki Aldasoro & Luitgard A M Veraart, 2022. "Systemic Risk in Markets with Multiple Central Counterparties," BIS Working Papers 1052, Bank for International Settlements.
    12. Jukonis, Audrius & Letizia, Elisa & Rousová, Linda, 2022. "The impact of derivatives collateralisation on liquidity risk: evidence from the investment fund sector," Working Paper Series 2756, European Central Bank.
    13. Barnett, William A. & Wang, Xue & Xu, Hai-Chuan & Zhou, Wei-Xing, 2022. "Hierarchical contagions in the interdependent financial network," Journal of Financial Stability, Elsevier, vol. 61(C).
    14. H Peyton Young & Mark Paddrik, 2017. "How Safe are Central Counterparties in Derivatives Markets?," Economics Series Working Papers 826, University of Oxford, Department of Economics.
    15. Ron Berndsen, 2021. "Fundamental questions on central counterparties: A review of the literature," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 41(12), pages 2009-2022, December.
    16. Luitgard Anna Maria Veraart, 2022. "When does portfolio compression reduce systemic risk?," Mathematical Finance, Wiley Blackwell, vol. 32(3), pages 727-778, July.
    17. David Aikman & Daniel Beale & Adam Brinley-Codd & Anne-Caroline Hüser & Giovanni Covi & Caterina Lepore, 2023. "Macro-Prudential Stress Test Models: A Survey," IMF Working Papers 2023/173, International Monetary Fund.
    18. Radoslav Raykov, 2024. "Decomposing Large Banks’ Systemic Trading Losses," Staff Working Papers 24-6, Bank of Canada.
    19. Marco Bardoscia & Paolo Barucca & Stefano Battiston & Fabio Caccioli & Giulio Cimini & Diego Garlaschelli & Fabio Saracco & Tiziano Squartini & Guido Caldarelli, 2021. "The Physics of Financial Networks," Papers 2103.05623, arXiv.org.
    20. Mark Paddrik & Simpson Zhang, 2019. "Central Counterparty Default Waterfalls and Systemic Loss," 2019 Meeting Papers 213, Society for Economic Dynamics.
    21. Bardoscia, Marco & Caccioli, Fabio & Gao, Haotian, 2022. "Efficiency of central clearing under liquidity stress," Bank of England working papers 1002, Bank of England.
    22. Ahn, Dohyun & Kim, Kyoung-Kuk & Kwon, Eunji, 2023. "Multivariate stress scenario selection in interbank networks," Journal of Economic Dynamics and Control, Elsevier, vol. 154(C).
    23. Jin, YangKyu & Suh, Sangwon, 2024. "Procyclical variation margins in central clearing," The North American Journal of Economics and Finance, Elsevier, vol. 70(C).
    24. Zachary Feinstein & Andreas Sojmark, 2022. "Endogenous distress contagion in a dynamic interbank model: how possible future losses may spell doom today," Papers 2211.15431, arXiv.org, revised Aug 2024.

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    More about this item

    Keywords

    financial networks; contagion; stress testing; credit default swaps;
    All these keywords.

    JEL classification:

    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • L1 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance

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