A Theory of Collateral Requirements for Central Counterparties

This paper develops a new framework for the design of collateral requirements in a centrally cleared market. Clearing members post collateral - initial margins and default funds - to increase their pledgeable income, thereby credibly committing to risk management. We show that initial margins are more cost-effective in aligning members' incentives for risk management. In contrast, default funds are more valuable to enhance the central counterparty's (CCP) resilience by allowing members to mutualize losses. In setting collateral requirements, the CCP balances the opportunity cost of collateral, its effectiveness in providing incentives, and the cost of CCP recapitalization. Our model predicts extensive use of initial margin during normal times, and of default funds under extreme market scenarios