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In centrally cleared markets, a central counterparty (CCP) sits at the centre of transactions, becoming the buyer to every seller and the seller to every buyer. In practice derivatives clearing is characterised by a small set of CCPs. Importantly, a limited number of large banks link these CCPs together, representing the joint clearing membership that together accounts for the lion’s share of clearing volumes.
Central clearing is a key feature of global derivatives markets. The mandates to centrally clear derivatives in the aftermath of the Great Financial Crisis (GFC) have considerably altered the shape of financial networks. Centrally cleared markets are characterised by a central counterparty (CCP) which sits at the centre, becoming the buyer to every seller and the seller to every buyer. Theory points to efficiency gains from having a single CCP (Duffie & Zhu, 2011). In practice, however, derivatives clearing is characterised by a small set of CCPs, rather than a single CCP. Importantly, linking these CCPs is a limited number of large banks that clears across CCPs. This group of banks represents the so-called joint clearing membership, which accounts for the lion’s share of clearing volumes. An example of this can be seen in Figure 1.
Figure 1: Network of clearing members and CCPs 
Joint clearing membership has a bearing on the structure of interconnections in financial networks. Indeed, connections between CCPs arise due to the shared clearing membership, and connections between clearing members arise via CCPs. Accordingly, risk transmission in financial networks can be affected (Faruqui et al. (2018)). In the context of centrally cleared markets, a central role in risk transmission is played by the default management mechanism of CCPs. This is usually described in terms of the so-called “default waterfall”, which specifies the order of loss absorption of resources available to CCPs (Duffie (2014)).
Joint clearing membership may affect various layers of the default waterfall. At a general level, the default waterfall can be split into losses paid by defaulters and by survivors. Initial losses are paid for by defaulting members in the form of initial margins and their default fund contributions. Higher losses are paid for by the CCP (through so-called “skin-in-the-game”, i.e. equity) and surviving clearing members (through their default fund contributions and potentially additional contributions). We show that joint clearing membership affects both parts of the default waterfall – namely how both defaulters and survivors pay – and that that this gives rise to different contagion channels.
Two contagion channels are considered. The first is the fire-sale channel of initial margins. Initial margins, typically in the form of collateral, serve as the first line of defence to cover losses. A simultaneous default by a joint clearing member at more than one CCP can lead to losses larger than those covered by initial margins at all the CCPs where the member clears. This situation can be considerably worsened if the collateral used is illiquid, as forced liquidation will have an outsize impact on prices, potentially leading to more losses and defaults.
The second channel we consider is associated with one of the last layers of the default waterfall: variation margin gains haircutting (VMGH). When a stressed CCP uses VMGH it only pays out a fraction of the variation margin it owes while still receiving full payments on the variation margin owed by its clearing members. We show that one CCP’s VMGH can transmit losses to another CCP via their joint clearing members.