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A Theory of Collateral Requirements for Central Counterparties

Author

Listed:
  • Jessie Jiaxu Wang

    (Department of Finance, W. P. Carey School of Business, Arizona State University, Tempe, Arizona 85287)

  • Agostino Capponi

    (Department of Industrial Engineering and Operations Research, Columbia University, New York, New York 10027)

  • Hongzhong Zhang

    (Department of Industrial Engineering and Operations Research, Columbia University, New York, New York 10027)

Abstract

This paper develops a framework for designing collateral requirements in a centrally cleared market. Clearing members post collateral—initial margins and default funds—to increase their pledgeable income, thereby committing to risk management. The two types of collateral, however, are not perfect substitutes. By achieving loss mutualization, default funds are economically more efficient than initial margins in aligning members’ incentives for risk management ex ante. The optimal mix of collateral resources balances the efficiency in providing incentives with their relative opportunity costs. Our model predicts increased use of initial margins under stringent capital requirements and of default funds under distressed market scenarios.

Suggested Citation

  • 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.
    • Handle: RePEc:inm:ormnsc:v:68:y:2022:i:9:p:6993-7017
    DOI: 10.1287/mnsc.2021.4145
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    References listed on IDEAS

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