Journal of Financial Market Infrastructures

Welcome to the summer 2018 edition of The Journal of Financial Market Infrastructures. Our final issue of Volume 6 contains three papers on central counterparties (CCPs) and one paper on large-value payment systems (LVPSs).
The first paper in this issue, “A CCP is a CCP is a CCP” by Robert T. Cox and Robert S. Steigerwald, provides the reader with an in-depth analysis of the differences between a CCP and a bank.¹ The authors analyze the different roles that capital, collateral and risk management play in both types of financial institution. As they state, banks are risk takers, at the very least because they undertake maturity transformation, while CCPs are risk managers. Understanding these differences is essential for policy-making and international standard setting, not only for CCPs in the normal resilience mode but also for CCPs undergoing the extreme case of resolution. Cox and Steigerwald draw several important policy conclusions, one of which refers to the significance of own capital: a commodity that is quantitatively crucial for banks but plays a qualitative role for CCPs.

“Freeriding on liquidity in the Colombian large-value payment system” by Constanza Martínez and Freddy Cepeda, this issue’s second paper, takes us outside central clearing and into the world of real-time gross settlement systems. Because of the relatively high liquidity need in those systems, banks rely heavily on incoming funds. Therefore, a free rider problem may exist if some of the participants consciously decide to delay their outgoing payments.² The authors investigate the extent to which this problem occurs in the Colombian case. For the Colombian LVPS (the CUD system), they find some evidence of the free rider problem but conclude that the negative effect on liquidity provision in the payment system is small.

In “Measuring system-wide resilience of central counterparties”, our third paper, Stathis Tompaidis’s research transcends the level of individual financial market infra- structure to focus on the financial system level: the entire network of multiple CCPs and their participants. Stress testing is a daily task for a CCP, but it is still early days for stress testing at the system level. The author proposes a framework for extending existing stress test results obtained at individual CCPs to create a system-wide stress test. That framework is compared with the two existing system-wide stress tests organized by the US Commodity Futures Trading Commission (the US perspective) and the European Securities Market Authority (the EU perspective). The paper concludes with suggestions for improvements, such as substantially increasing the number of stress scenarios.³

The issue’s fourth paper is a forum paper: “One for my baby (and one more for the road): incentives, default waterfalls and central counterparty skin-in-the-game” by Rebecca Lewis and John McPartland. In the case of for-profit CCPs, the authors argue, two tranches of their capital should be placed in the prefunded part of the waterfall, directly after the defaulters pay part (the junior tranche, or skin-in-the-game) and directly after the survivors pay part (the senior tranche, which would be at the very end of the prefunded waterfall). Almost all CCPs considered in the paper presently have the junior tranche but not the senior tranche. Lewis and McPartland also discuss the impact of changing the amount of skin-in-the-game. The arguments in favor of two tranches come from the balanced incentive structure for the CCP, its participants
and shareholders.⁴

Ron Berndsen
LCH and Tilburg University

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¹ A related contribution can be found in Manning, M. J., and Hughes, D. (2016). Central counterparties and banks: vive la difference. The Journal of Financial Market Infrastructures 4(3),
1–24.
² A related contribution can be found in Diehl, M. (2013). Measuring freeriding in large-value payments systems: the case of TARGET2. The Journal of Financial Market Infrastructures 1(3),
31–53.
 ³ Recently, CPMI–IOSCO published a report on this topic: “Framework for supervisory stress testing of central counterparties” (April 2018), see www.bis.org/cpmi/publ/d176.htm.
⁴ Related contributions on skin-in-the-game are: Cox, R. T. (2015). Cave quid optes: waterfalls and
central counterparty capital. The Journal of Financial Market Infrastructures 3(4), 63–71; Carter, L., and Garner, M. (2016). Skin in the game: central counterparty risk controls and incentives. The Journal of Financial Market Infrastructures 4(3), 39–54; Murphy, D. (2017). I’ve got you under my skin: large central counterparty financial resources and the incentives they create. The Journal of Financial Market Infrastructures 5(3), 1–18.