The two functions of a CCP – and why they don’t have to be united March 3, 2012 at 5:35 pm
In a previous post, I introduced the notion of a central margin custodian: a body which administers and settles both initial and variation margin for OTC derivatives. You might ask what CCPs do above and beyond this – the answer is that they act as a guarantor of derivatives receivables. As a technical matter the CCP is actually a party (the clue is in the ‘P’) to cleared trades, but it need not be. You would get the same functionality if the CCP acted as an insurer, where the thing insured is the cleared derivatives receivable.
Thus we have CCP = CMC + derivatives receivable insurer
Of course, insurers need financial resources, and that is what the CCP’s default fund (and the wafer-thin slice of equity they have) are for. They are, to be precise, amounts of money that are available to meet credit losses above IM. Given that the CMC covers losses up to IM, the decomposition is precise.
Now thinking about things this way has the key advantage that we can see the relationship between IM and DF more clearly. From the CMC’s perspective, it doesn’t care how high (or low) IM is: it is just an amount of money to be collected. (Well it might have a preference for it to be higher so that it has more funds under management, but that is hopefully a secondary effect.) For the insurer, though, it matters a lot. The tranche of loss it has insured is attached at IM, so the lower IM is, the more risk it has. It will need more financial resources – more DF – to support that risk. In fact one thing that would make me feel more comfortable about CCPs would be knowing that the insurance premium charged was commercial: would Berkshire Hathaway, say, write credit insurance on the cleared derivatives receivable if the premium available was the default fund contributed charged by LCH, and IM was determined by LCH’s model? How about ICE or CME? And if Berkshire wouldn’t trade at that level, what does that tell you about the safety of the leading CCPs?
Or, to put it another way, suppose that the credit insurance part of a CCP was a standalone business, with the CCP’s capital and DF behind it. How would it be rated?