Loading...
Please wait, while we are loading the content...
Similar Documents
Should Fast-Moving Capital in Crowded Trades Be Avoided ? 1
| Content Provider | Semantic Scholar |
|---|---|
| Author | Menkveld, Albert J. |
| Copyright Year | 2015 |
| Abstract | Should Fast-Moving Capital in Crowded Trades Be Avoided? If all intermediaries enter the same market-making “bet” on the same side, fast-moving capital gets tied up in a crowded trade. This creates systemic risk for a central clearing party (CCP) since multiple traders might default when the bet turns (extremely) sour. The CCP then has to unwind the inherited portfolios in a market without fast-moving capital and potentially pay a fire sale premium. Equilibrium analysis reveals that crowded trades are socially costly, but so is the other extreme: perfect diversity. Surprisingly, the CCP needs most collateral in the latter case, either as margin or to fill the default fund. Mandatory central clearing removes counterparty risk from derivatives trading and concentrates it in the central clearing party, CCP (Koeppl and Monnet, 2014). The CCP becomes a “systemic node” in the new financial architecture. Its risk management becomes critically important (Bernanke, 2011). We focus on two standard tools used by CCPs: margins and the default fund.1 This paper analyzes a trade economy with a CCP that maintains a default fund large enough to stay afloat at all times. The fund should be able to absorb losses in the trade portfolios it inherits from clearing members in default. These are mark-to-market losses, net of the margin posted by the member. The default fund should be able to pay for these losses but also for additional losses in case the CCP needs to unwind these portfolios in the market at fire sale prices. The paper’s main contribution is an equilibrium analysis of liquidation cost in “extreme but plausible” market conditions (BIS-IOSCO, 2004; ESMA, 2012, Section 4.5.4 and Article 41, respectively). The constraint of a large enough clearing fund creates a “self-financing” financial market infrastructure (FMI). This exogenous constraint is admittedly extreme, but serves to identify the social cost and benefit of tying up capital either through margin or through a contribution to the default fund. A discussion of “waterfall” default beyond the default fund is outside the scope of this paper (Duffie, 2010a, 2014; BISIOSCO, 2014). The paper’s focus is exclusively on CCP risk as caused by default of intermediaries; in the model endusers do not default by assumption. Intermediaries are therefore the only ones who need to post margin and contribute to the default fund. This is in line with recently published guidelines that stipulate that only “financial firms and systemically important non-financial entities” need to post margin (BCBS and IOSCO, 2013, 2.4, p. 9). These are often highly leveraged institutions that operate under limited liability. 1Resolution schemes in case of (multiple) member default and the size of a default fund in particular are quickly taking central stage in the public discussion on central clearing. JPMorgan recently called for a larger fund. See “JPMorgan tells clearers to build bigger buffers,” Financial Times, September 11, 2014. |
| File Format | PDF HTM / HTML |
| Alternate Webpage(s) | http://www.efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL%20MEETINGS/2015-Amsterdam/papers/EFMA2015_0399_fullpaper.pdf |
| Language | English |
| Access Restriction | Open |
| Content Type | Text |
| Resource Type | Article |
