Challenging Skin in the Game

By: John McPartland, Director of Research, Hidden Road Partners LP Apr 2021

In the old days of the 1970s, few understood what the term Skin in the Game signified. The International Monetary Market (IMM (part of the CME)) introduced the “good to the last drop” rule, which involved borrowing financial mass from its clearing members in times of loss. The IMM Rule Book duly listed the sequential tranches of financial assets that would be brought to bear should the Clearing House suffer financial loss. Moreover, the indeterminate term “excess retained earnings” of the Clearing House would be brought into play, subsequent to initial margin, exchange memberships and the guarantee fund deposits of the defaulter. The general perception then was that the 1970’s version of Skin in the Game was not unlike an insurance deductible. In other words, before any remaining loss went to the clearing membership for satisfaction, a material amount of cash of the CCP would go first. Skin in the Game seemed largely based on the CCP’s ability to pay.

Also, at the time, in downtown Chicago, the Board of Trade Clearing Corporation’s (BOTCC)’s default waterfall operated quite differently. BOTCC clearing members were required to purchase stock in the CCP. However, few realized that BOTCC stock was not “No Par” stock. Instead, it had a par value, which meant that buyers of BOTCC stock did not pay the full price when the stock was issued. Therefore, under U.S. corporate law, BOTCC’s was able to assess and tap its clearing member shareholders for additional amounts, up to the par value of the stock. Implicit in this structure, was that BOTCC had no Skin in the Game as the capital of BOTCC was its guarantee fund.

In the early 1980’s banks started their own Futures Commission Merchants (FCMs) and became clearing members. One or two banks joined the IMM as early clearing members until their bank regulators discovered IMM’s good to the last drop rule. Clearing membership was then quickly switched to an Edge Act corporation or a De Novo subsidiary of either the bank or the bank holding company. What today is understood as skin in the game was neither an issue nor the subject of conversation.

At the start of this century exchanges and CCPs demutualized, and converted exchange memberships into common stock, becoming for-profit enterprises. Bank clearing members literally rushed to sell their common stock in the Initial Public Offering (IPO) at a small fraction of what that stock is worth today. At the time, some believed that banks could not own common stock. Without dwelling on the issue, if the bank-parented clearing members would have retained their common stock in the investment portfolio of their respective institutions[1] they would today, as a group, constitute a plurality of the directors of the boards of the exchanges and CCPs that they seem to want to exert such control over today.

In 2010, national derivatives regulators and several central banks created what is now the CPMI/IOSCO group to establish global principles for prudential operation of financial market infrastructures, including derivatives CCPs. CPMI/IOSCO provided increasingly granular interpretive guidance with respect to the principles that it had established. At some point this included guidance that CCPs should provide Quarterly CCP Quantitative Disclosures. About this time, attention began to be focused on the amount of CCP funds that were at risk in the CCPs’ default waterfalls; and by extension, some comparisons of Skin in the Game could be made across CCPs. CCP Skin in the Game quickly became a subject for academic study and public policy debate with an almost religious fervour not seen perhaps since the Medieval Crusades.

Important questions arose, some of which are merited here, including: what is Skin in the Game designed to achieve; and how much Skin in the Game is enough to accomplish its objectives?

What are the Objectives of Skin in the Game?

Two very different answers apply. Most commentators posit that Skin in the Game places an amount of monetary resources of the CCP at risk within the default waterfall. Therefore, it provides the CCP and by implication, the senior management, and shareholders of the CCP, with a vested financial interest in managing CCP risks conservatively; thereby keeping the potential for the CCP losing all or part of its Skin in the Game at bay. Others believe that CCP Skin in the Game should comprise a material portion of the CCP’s default waterfall. Both approaches are examined here.

In practice, Skin in the Game tends to comprise a small fraction of most CCPs’ default waterfalls. Even so, many believe even this limited exposure provides beneficial incentives for CCP management to act prudently and conservatively. Many if not most of the largest CCPs are part of publicly traded companies, and as such, the details of the executive compensation programs of senior executives of such CCPs is readily available in the public domain. In one of the Skin in the Game panels at the latest WFE Derivatives Conference on 20th April, I referenced CME stock declined approximately 11% immediately after financial problems surfaced at MF Global in November of 2011. Equally, Nasdaq stock declined approximately 14.6% in the aftermath of the Einar Aas default in September of 2018. Although presented in broad brush strokes, this analysis is grounded in fact. Let us assume that a “near miss” with a clearing member will cause a stock decline of 11% and an actual default, 14.6%. Extrapolating from this, the following table represents the very real potential repercussions of clearing member failure on current and past CME CCP senior executives.

Table: Repercussion of clearing member failure on CME Executives shareholding (current and past)



Near Miss


Kim Taylor

120,590 CME shares @$136/share




Sunil Cutinho

31,182 CME shares

@ $210/share




Howard Siegel

80,382 CME shares





Sources and notes: ¹ Information as of 11/2017; ² Information as of 8/2019; ³Howard Siegel, a CME Board Member, is the Chairman of the CME Clearing House Risk Committee and the CME Board’s Clearing House Oversight Committee. Information as of 8/2019.

Figures in the table above clearly show that CCP executives participating in similar executive incentive compensation programs at other publicly traded companies would have a truly prodigious personal financial incentive to avoid clearing member losses, almost at any cost. The public policy position that CCPs should increase their respective Skin in the Game to appropriately incentivise CCP executives to act prudently simply does not hold water, at least not among the largest global CCPsMoreover, the table does not reflect stock option grants and other forms of incentive compensation that would only increase the magnitude of personal financial loss associated with clearing member difficulties. Many global CCPs that are not publicly traded, nonetheless have similar programs where performance bonuses, and deferred compensation packages are adversely impacted by potential clearing member defaults.

How much Skin in the Game is enough to accomplish conservative behaviour? 

None. Senior CCP executives at major global CCPs are clearly and sufficiently motivated by the incentive compensation programs of their employers. If Skin in the Game were zero, CCP executives at major CCPs would be more than motivated to be prudent and conservative. Publicly available data speaks for itself. Analysing CCPs’ levels of Skin in the Game for statistically significant levels of behavioural attributes is a fool’s errand.

Having soundly defeated the specious position that Skin in the Game is needed to motivate CCP senior management, we turn to Skin in the Game as a significant loss absorbing component of a CCP default waterfall. Many industry professionals refer to the requirement for a “Cover 2” default fund. What is not clear, and what the CPMI/IOSCO group should clarify is whether Skin in the Game counts towards satisfying the Cover 2 standard. That is, is it a Cover 2 default fund or a Cover 2 default waterfall standard?

If the international standard is a Cover 2 default waterfall, then the only conclusion that can be reached is that the large bank clearing members that incessantly advocate for CCPs to significantly increase their respective Skin in the Game, will want to take an equal amount of their money out. Should this be the case, it sends the wrong message to the industry, particularly the end-user community.

Should large banks want to reduce their contributions to CCPs’ default waterfalls, they could easily do so and without any regulatory approval. It would simply issue a Catastrophe Bond, consequently, if the bank’s FCM lost all or part of its guarantee fund deposits with any of the very largest global CCPs, the principal loss would be borne by the bond holders. As actual default fund losses among the very largest of global CCPs is virtually zero since banks entered the industry in the early 1980’s, specialists in Catastrophe Bonds say they could be issued at an interest rate of approximately half the return on equity (ROE) of major banks.

If contributing appropriate amounts into major CCPs’ default funds—where the largest single source of concentration margin originates from those same banks— is so abhorrent to the banks, then they should just issue Catastrophe Bonds to pay someone else to assume the default risk. Since banks have a literal army of analysts that have or should have already considered this alternative, we might assume that the largest clearing members have ulterior motives that are not readily discernible.

One could begin to make a cogent argument that Skin in the Game is simply a manufactured issue, ever heightened by the voices of representatives from the largest clearing members, bound and determined to either exercise the maximum amount of control possible over the CCPs or to remove the maximum amount of their funds from CCPs’ default waterfalls, or both.

Skin in the Game is far from the most pressing issue that the global derivatives industry faces today. Concentration in the clearing ecosystem is. Curious then, that the same voices singing the Skin in the Game verses incessantly, seem to never utter a word about the dangers of clearing member concentration.

[1] There was an exception to this widely held belief as insolvent bank customers would often reorganize out of bankruptcy and exchange outstanding bank loans for common stock in the reorganized company. Banks were permitted to hold such common stock in the bank’s Investment Portfolio if the common stock that was received by the bank was the result of the bank previously owning a permissible asset, more typically a commercial loan, but in the instant case, exchange memberships that morphed into common stock. The point being, that banks did not have to sell the common stock that was received when exchanges converted their exchange memberships into common stock.

The views, thoughts and opinions contained in this Focus article belong solely to the author and do not necessarily reflect the WFE’s policy position on the issue, or the WFE’s views or opinions.