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The results suggest that risk-shifting problems can be important in CCPs. The distortions we found are likely to arise in other contexts, since CCPs are often thinly capitalised compared to their largest potential clearing liabilities.
Risk-shifting incentives can be limited in several ways:
CCPs could operate with higher equity ratios. Given the size of centrally cleared markets, however, it seems unlikely that CCPs can reach capitalisation levels that completely prevent risk-shifting. W
Well-designed default management schemes ('default waterfalls') can also reduce risk-shifting incentives. By combining tranches of equity with additional resources called from surviving members, the sensitivity of the CCP’s equity value to settlement prices near distress can be reduced.
Risk-shifting incentives can be limited through better CCP governance. We highlighted the importance of two types of members. The first is hedgers, who value the continuation of clearing services. The second is liquidity providers, who derive little value from future clearing services. A governance structure that gives more weight to hedgers is less likely to have interests aligned with those of a defaulting member. Therefore, it is less likely to delay the liquidation of a defaulting member’s position – a decision which proved fatal to the CLAM.
Finally, the findings have implications for the current debate on the trade-off between rules and discretion in CCP management. While discretion over risk-management can enable the CCP to use more information about the conditions of members, our research shows that managerial discretion can also be used to lower total CCP value. Thus, if risk-shifting incentives are large enough, a management of CCPs based on strict rules, near distress, can reduce expected default costs.
This also supports the idea that, if private attempts to negotiate a recovery are inefficiently distorted by risk-shifting incentives, it is desirable that resolution authorities intervene early. If the regulatory environment evolves this direction, that would be a good thing.