A central counterparty (CCP) can be characterised as a private company with a public mission, given a CCP’s systemically important nature. Following from that, it is no surprise that the academic literature on CCPs has focused on incentives for the CCP to pursue the public goal of financial stability rather than the private goal of profit maximisation. In this context a debate with a particularly high profile is the so-called skin-in-the-game (SITG).
Skin-in-the-game relates to a part or the whole of a CCP's own capital which is exposed to clearing member default losses. By definition, skin-in-the-game forms part of the prefunded waterfall and as such can absorb a loss which exceeds the full defaulter's contribution. In general, SITG can be junior to the survivor's part of the default fund or senior to that, or both (i.e. two layers of SITG). In the first case the CCP suffers a loss of its own resources prior to any surviving clearing member while in the second case the loss is only incurred by the CCP after the default fund is exhausted. In the EU, the legal requirement is that 25% of the CCP’s regulatory capital should consist of SITG.
In practice, skin-in-the-game cannot quantitatively be considered as a meaningful loss-absorbing component given its small size relative to the other available prefunded financial resources. For example, in the EU, skin-in-the-game accounts for only 0.2% of the average pre-funded waterfall of the 16 CCPs considered in the third EU-wide stress test conducted by ESMA, published in July 2020 on its website.
This does not mean that SITG lacks a useful function. On the contrary, it is considered by many scholars to provide a powerful incentive to the board and senior management to take risk management seriously (see e.g. Cox and Steigerwald, 2016; Cerezetti et al., 2019a; Lewis and McPartland, 2018; McLaughlin, 2018). Especially a prudent setting of initial margin is incentivised as that protects consumption of the SITG in the case of a member default. In general, CCPs and their clearing members face different interests, where CCPs prefer lower SITG and clearing members higher SITG (Murphy, 2017). The recommendation in the academic literature is to scale skin-in-the-game such that it is material in terms of the CCP’s capital.
There are however limits to increasing SITG (Cox, 2015). Carter and Garner (2016) point at the diminished incentives for clearing members to fulfil their role in the default management process properly, if SITG becomes too large. But also, on the basis of theoretical models, (Murphy, 2017; McLaughlin, 2018) show that with higher SITG the clearing fees are likely to increase, which would increase the cost of clearing across the financial sector. The underlying mechanism is that the increase in SITG would lower the return on equity and so, to compensate shareholders clearing fees would have to increase. As such there is a trade-off between higher SITG and clearing costs.
This is an abridged version of Berndsen, R. (2020), Five Fundamental Questions on Central Counterparties. (CentER Discussion Paper; Vol. 2020-028), Center for Economic Research, Tilburg University,
To read more: https://www.tilburguniversity.edu/research/economics-and-management/publications/discussion-paper which includes all of the references in the main text.
Ron Berndsen is professor of Financial Market Infrastructures (Economics Dept.), Tilburg University, The Netherlands and can be reached at [email protected]. The author is also an independent director and chair of the Risk Committees of LCH Ltd and LCH SA as well as editor-in-chief of the Journal of Financial Market Infrastructures. The views expressed in this paper do not necessarily reflect the views of LCH or Tilburg University.