Instructional Video: Chapter 5: Exchanges and OTC Markets & Chapter 6: Central Clearing

[SKhai2554]

Hello,

I was just comparing Default fund contribution Waterfall losses chart from the video with the GARP textbook. The sequence in both is different.
Based the book - the funds are used in the following order:

1. Initial margin provided by the member,
2. Default fund contribution of the member,
3. Default fund contributions of other members, and
4. Equity capital of the exchange

In the video:

1. Initial margin provided by the member,
2. Default fund contribution of the member
3. Equity capital of the exchange, and
4. Default fund contributions of other members

CCP equity (below) = Equity capital of the exchange (from the book) unless I misunderstood. I am confused about the order at the moment.

As showing in the learning video at 18mins.

 

[Clay Carter]

Hello,

I was just comparing Default fund contribution Waterfall losses chart from the video with the GARP textbook. The sequence in both is different.
Based the book - the funds are used in the following order:

1. Initial margin provided by the member,
2. Default fund contribution of the member,
3. Default fund contributions of other members, and
4. Equity capital of the exchange

In the video:

1. Initial margin provided by the member,
2. Default fund contribution of the member
3. Equity capital of the exchange, and
4. Default fund contributions of other members

CCP equity (below) = Equity capital of the exchange (from the book) unless I misunderstood. I am confused about the order at the moment.

As showing in the learning video at 18mins.
View attachment 4306

@SKhai2554

Hi,

I believe the confusion is coming from the sequences is the placement of the CCP's equity capital. While both can technically be correct the video’s description is more inline with industry practice.

The CCP is most likely to use its first line of equity capital before going after non-defaulting members’ default fund. However, if the loss is bad enough the CCP will go after the non-defaulting members’ fund and then be responsible for all the losses thereafter.

The reason most traders prefer a CCP to have a first-line equity loss before resorting to non-defaulting members' default fund contributions is that without this initial buffer, the CCP might take on excessive risk. This is known as moral hazard. Please see the chart below.



Flow of the Loss Waterfall

• Step 1: Defaulting Member's Margin:
  • Losses are first covered by the initial margin posted by the defaulting member.
  • If the losses exceed the initial margin:
• Step 2: Defaulting Member's Default Fund Contribution:
  • The next resource is the defaulting member's contribution to the default fund.
  • If the losses still exceed these contributions:
• Step 3: CCP's Skin in the Game (First Layer):
  • The CCP uses its own funds, showing its commitment to risk management.
  • If the losses are not yet covered:
• Step 4: Non-Defaulting Members' Default Fund Contributions:
  • Contributions from other clearing members' default funds are used, sharing the burden among all members.
  • If losses continue to exceed available resources:
• Step 5: CCP's Skin in the Game (Second Layer):
  • The CCP may use additional funds from its own resources.
  • If additional coverage is needed:

 

[SKhai2554]

Thank you, I appreciate the quick response.