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Market liquidity, closeout procedures and initial margin for CCPs

Author

Listed:
  • Fernando V. Cerezetti
  • Emmanouil N. Karimalis
  • Ujwal Shreyas
  • Anannit Sumawong

Abstract

Closeout procedures enable central counterparties (CCPs) to respond to events that challenge the continuity of their normal operations, most frequently triggered by the default of one or more clearing members. The procedures typically entail three main phases: splitting, hedging, and liquidation. Together, these ensure the regularity of the settlement process through the prudent and orderly liquidation of the defaulters’ portfolios. Traditional approaches to CCPs’ margin requirements typically assume a simple closeout profile, not accounting for the ‘real life’ constraints embedded in the management of a default. The paper proposes an approach to assess how distinct closeout strategies may expose a CCP to different sets of risks and costs taking into account real-life frictions. The proposed approach enables the evaluation of a full spectrum of hedging strategies and the assessment of the trade-offs between the risk-reducing benefits of hedging and the transaction costs associated with it. Using an unexplored set of transactional level data, the proposed framework is evaluated assuming the hypothetical default of a real CCP clearing member. We consider the worst-case loss of a large interest rate swap portfolio observed over the past 10 years (i.e. 2005–2015) and show that an efficient hedging strategy which minimises risk may not be optimal when transaction costs are taken into account. The empirical analysis suggests that transaction costs are a significant factor and should be accounted for when designing a hedging strategy. Specifically, it is shown that the risk-reducing benefits arising from more tailored hedging strategies may introduce higher transaction costs, and therefore may change the effectiveness of the strategies.

Suggested Citation

  • Fernando V. Cerezetti & Emmanouil N. Karimalis & Ujwal Shreyas & Anannit Sumawong, 2019. "Market liquidity, closeout procedures and initial margin for CCPs," The European Journal of Finance, Taylor & Francis Journals, vol. 25(7), pages 599-631, May.
  • Handle: RePEc:taf:eurjfi:v:25:y:2019:i:7:p:599-631
    DOI: 10.1080/1351847X.2018.1496944
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    Cited by:

    1. Rodney Garratt & David Murphy & Travis D. Nesmith & Xiaopeng Wu, 2023. "Optimal Bidder Selection in Clearing House Default Auctions," Finance and Economics Discussion Series 2023-033, Board of Governors of the Federal Reserve System (U.S.).
    2. Berndsen, Ron, 2020. "Five Fundamental Questions on Central Counterparties," Other publications TiSEM 1f3bd844-92ab-4104-8f57-9, Tilburg University, School of Economics and Management.
    3. Injun Hwang & Baeho Kim, 2022. "A systemic change of measure from central clearing," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 42(9), pages 1738-1754, September.
    4. 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.
    5. Marco Bardoscia & Ginestra Bianconi & Gerardo Ferrara, 2019. "Multiplex network analysis of the UK over‐the‐counter derivatives market," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 24(4), pages 1520-1544, October.

    More about this item

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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