Margins as early warning for CCPs to prevent contagion

Central clearing counterparties (CCPs) manage risk by requiring clearing members to post margins.

This paper highlights margins as 'canaries in the coal mine,' inducing early defaults of fragile counterparties before contract maturity.

This early default is beneficial as it allows the CCP to transfer positions to healthier market participants while uncertainty about final payoffs remains.

This process preserves risk sharing and reduces the likelihood of losses overwhelming remaining clearing members at maturity.

Margins, counterparty replacement, and loss sharing thus reinforce each other: margins reveal fragility, replacement restores risk-sharing capacity, and loss sharing ensures the CCP meets its obligations.

The total amount of margin held by CCPs exceeds $1.5 trillion, with daily flows of more than $30 billion, underscoring their practical significance in financial infrastructure.

Optimal use of CCP risk management tools varies with systemic fragility.

While loss sharing suffices for low fragility, margins inducing early default and replacement become optimal when fragility is widespread, preventing cascading failures.

Early intervention via 'canary margins' is more valuable than late action, especially with limited underlying risk information.

These findings challenge the conventional view of margin procyclicality, suggesting higher margins can, under specific conditions, improve financial stability by enabling CCPs to screen for fragility and facilitate replacement.

The research also underscores the importance of CCPs' access to a healthy pool of replacement counterparties, a crucial element often overlooked in current regulatory frameworks.