Managing market liquidity risk in central counterparties

In the event of a clearing member’s default, and as part of its default management process, a central counterparty (CCP) will need to hedge the defaulter’s portfolio and close out its positions. However, the CCP may not be able to do this without incurring additional losses if the market is illiquid or the portfolio contains large, concentrated positions. To mitigate this liquidity risk, CCPs often require members to post additional collateral to the initial margin in the form of concentration add-ons. In the absence of a quantitative regulatory standard for calculating concentration add-ons, this paper discusses the different approaches to incorporating market liquidity risk within a CCP’s default waterfall and the challenges that these approaches pose.