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Market liquidity, closeout procedures and initial margin for CCPs

Author

Listed:
  • Cerezetti, Fernando

    (Bank of England)

  • Sumawong, Anannit

    (University of Sussex)

  • Karimalis, Emmanouil

    (Bank of England)

  • Shreyas, Ujwal

    (Bank of England)

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 ensure the regularity of the settlement process through the prudent and orderly closeout of the defaulter’s portfolio. Traditional approaches to CCPs’ margin requirements typically assume a simple closeout profile, and do not account for the ‘real-life’ constraints embedded on the management of a default. The paper proposes an approach of evaluating how distinct closeout strategies may expose a CCP to different sets of risk and costs, and consequently could impact the sufficiency of financial resources to cover its risk exposure to a default. The approach is based on a counterfactual simulation, and evaluates a full spectrum of hedging strategies in an exploratory and model-free manner, deriving endogenous and market-dependent risk metrics. Using the trade repository data available to the Bank (as a result of EMIR reporting) on over-the-counter (OTC) interest rate swaps (IRS) and ten years (ie 2005 to 2015) of information on related market risk factors, the paper derives empirically an efficient hedging strategy that minimizes the CCP’s risk exposure to a defaulting clearing member. Endogenous trade-off structures between total risk (market risk plus funding needs) and transaction costs are also established, with marginal sensitivities to individual components of the hedging strategy determined.

Suggested Citation

  • Cerezetti, Fernando & Sumawong, Anannit & Karimalis, Emmanouil & Shreyas, Ujwal, 2017. "Market liquidity, closeout procedures and initial margin for CCPs," Bank of England working papers 643, Bank of England.
    • Handle: RePEc:boe:boeewp:0643
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    File URL: https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2017/market-liquidity-closeout-procedures-and-initial-margin-for-ccps.pdf?la=en&hash=6FD50EF767C8ED66D2B028E49B86553A03510B25
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    Citations

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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. 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.
    3. Berndsen, Ron, 2020. "Five Fundamental Questions on Central Counterparties," Other publications TiSEM 1f3bd844-92ab-4104-8f57-9, Tilburg University, School of Economics and Management.
    4. 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.
    5. 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.

    More about this item

    Keywords

    CCPs; market liquidity; closeout procedures; initial margin;
    All these keywords.

    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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