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CDS Central Counterparty Clearing Liquidation: Road to Recovery or Invitation to Predation?

Recent regulation mandating the clearing of credit default swaps (CDS) by a Central Clearing Counterparties (CCP), has rendered the latter a systemically important institution, whose failure poses a serious threat to global financial stability. This work investigates the potential failure of a CCP initiated by the default of a large dealer bank and the unwinding of its positions. The theoretical model examines variation margin exchange between dealer banks and the price impact of liquidation and predatory selling. It provides a measure of covariance between assets in banks’ portfolios; price impact affects assets to varying degrees, based on their relative distance to defaulted assets. Key results show that liquidation lowers CCP profits, and how predation decreases the profits of all members, pushing banks to default. Furthermore, a hybrid CCP (vs. current) structure provides a natural disciplinary mechanism for predation. Also, it more incentive compatible for the CCP, in expectation of a large loss. A multi-period, dynamic simulation, calibrated to market data, provides parameter sensitivities, as well as, regulatory implications for a Lender of Last Resort in various liquidity scenarios.