Central Counterparties: Mandatory Central Clearing and Initial Margin Requirements for OTC Derivatives

Chapter 10

The Loss Waterfall and Loss Allocation Methods

I’ll tell you what happens when a CCP goes bust. There is mayhem – possibly greater mayhem than if the biggest dealers and banks in the world go bust.¹

Sir Paul Tucker (1958–)

10.1 POTENTIAL CCP LOSS EVENTS

This chapter defines the CCP loss waterfall in more detail. It also considers the potential loss allocation methods that CCPs may use when the financial resources within the waterfall cannot absorb a default. The capital requirements for the exposure that clearing members (and clients) have to CCPs (and each other) are also discussed.

10.1.1 Review of the loss waterfall

CCP insolvency would clearly represent a highly contagious event and it is therefore important for there to be a robust mechanism for wind-down or recovery. In contrast to formal bankruptcy, CCP loss allocation potentially allows a timely and orderly resolution of an extreme loss event that is likely preferable to CCP failure. However, determining the allocations of losses in a fair and transparent fashion is not trivial. Clearing members may be exposed to some combination of having to top-up exhausted default funds, be returned less margin than they are owed, having some or all of their trades torn-up (terminated) or even being forced to accept new trades at prices defined by the CCP. Such measures should be clearly written into CCP rules so as to provide clarity to mitigate systemic concerns and allow members to manage their risk to the CCP and allocate ...