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Show a loss waterfall at work through illustrations.

FRM® Part II · Credit Risk Measurement and Management · Central Clearing · FRM2.CR.18.f

The idea

The loss waterfall is the order in which resources absorb the loss from a clearing member's default. The typical sequence starts with the defaulter's variation and initial margin. Next comes the defaulter's default fund contribution, then the CCP's own capital (skin in the game). After that come the non-defaulting members' default fund contributions. Last are recovery tools such as further member assessments or variation margin gains haircutting. Work down the layers, subtracting each resource from the remaining loss until it reaches zero. Each layer is limited by its size. Suppose the loss is 150, the defaulter's IM is 80, its fund contribution is 20 and the CCP capital is 10. Then the mutualised fund bears 40. The usual mistakes are skipping a layer, using survivors' money before the CCP's capital, or splitting a mutualised loss equally rather than pro rata to contributions.

A practice question

From the question bank, with the reason each wrong option is wrong.

In a typical CCP loss waterfall, which resources are used first when a clearing member defaults?

  1. The non-defaulting members' default fund contributions.Why not: Uses mutualised resources before the defaulter's own.
  2. The CCP's own capital.Why not: Places skin in the game ahead of the defaulter's resources.
  3. The defaulter's own margin, followed by its default fund contribution. - correct
  4. Variation margin gains of surviving members.Why not: Uses a recovery tool, which sits at the end of the waterfall.

The defaulter pays first: its margin and then its fund contribution. Mutualised resources come later.

A harder one

A member defaults with a loss of USD 150 million after close-out. Its initial margin is USD 80 million and its default fund contribution is USD 20 million. The CCP's skin in the game is USD 10 million. The loss borne by the other members' default fund contributions is:

  1. USD 40 million - correct
  2. USD 50 millionWhy not: Omits the CCP's USD 10 million skin in the game.
  3. USD 60 millionWhy not: Omits the defaulter's USD 20 million default fund contribution.
  4. USD 70 millionWhy not: Deducts only the defaulter's initial margin (150 - 80) and goes straight to mutualised funds.

150 - 80 (IM) - 20 (defaulter's fund contribution) - 10 (CCP capital) = USD 40 million for the surviving members' fund.

The hardest tier

A default causes a loss of USD 700 million. The defaulter's initial margin is USD 150 million and its default fund contribution is USD 50 million. The CCP's skin in the game is USD 30 million. Surviving members' contributions total USD 400 million. How much of the loss must be met by recovery tools beyond the pre-funded resources?

  1. USD 470 millionWhy not: Counts the loss remaining after the defaulter's and CCP's resources but forgets the survivors' fund.
  2. USD 220 millionWhy not: Omits the defaulter's initial margin from the resources applied.
  3. USD 70 million - correct
  4. USD 100 millionWhy not: Omits the CCP's skin in the game from the resources applied.

700 - 150 - 50 - 30 = 470 remains after the defaulter's and CCP's resources. The survivors' fund of 400 absorbs most of it, leaving USD 70 million for assessments or other recovery tools.

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