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Contrast the initial margin and default fund contributions asked of clearing members, with respect to how losses are covered, what clearing costs and the moral hazard created.

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

The idea

Initial margin and default fund contributions both come from clearing members, but they work differently. Initial margin is defaulter-pays. It is calibrated to the member's own portfolio and held against its own default, so it keeps the member's incentives aligned with its risk. The default fund is mutualised. It is sized from aggregate stress, covers losses beyond the defaulter's resources, and spreads them across surviving members. On cost, both tie up collateral that has an opportunity or funding cost, and members' contributions can attract capital charges. On moral hazard, mutualisation means prudent members subsidise risk-takers, so a member bears less of the cost of its own risk-taking and monitors others less. A CCP that shifts resources from initial margin to the default fund therefore weakens incentives. The exam point is defaulter pays versus mutualised.

A practice question

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

Which clearing member resource follows the defaulter-pays principle?

  1. Initial margin, because it is calibrated to the member's own portfolio and applied first to that member's own default. - correct
  2. The default fund, because it is calibrated to the member's own portfolio and used only for its own default.Why not: The default fund is mutualised across members, not for a single member.
  3. The CCP's own capital, because it is posted by the defaulting member.Why not: The CCP's capital is the CCP's, not the member's.
  4. The surviving members' variation margin, because it is posted by the defaulter.Why not: Survivors' VM belongs to the survivors; it is a recovery tool only at the end of the waterfall.

IM is risk-based and member-specific, so the defaulter's own collateral absorbs the loss first. The default fund spreads remaining loss across members.

A harder one

A member has a USD 50 million initial margin and a USD 20 million default fund contribution. Collateral costs it 1.2% a year in net funding cost. The annual cost of both resources is closest to:

  1. USD 0.60 millionWhy not: Counts only the initial margin and omits the default fund contribution.
  2. USD 0.24 millionWhy not: Counts only the default fund contribution and omits the initial margin.
  3. USD 0.84 million - correct
  4. USD 8.40 millionWhy not: Treats 1.2% as 12%, a decimal slip.

Total collateral = 50 + 20 = 70. Cost = 70 x 0.012 = USD 0.84 million a year.

The hardest tier

To attract members, a CCP cuts initial margin and raises the default fund so that its total pre-funded resources stay unchanged. Which is the most likely consequence?

  1. More mutualisation and less defaulter-pays, which weakens the incentives of members to limit risk and increases cross-subsidy from prudent members to risk-takers. - correct
  2. Stronger incentives for members to limit risk, since a larger fund makes each member more cautious.Why not: Misreads the incentive effect; shared resources weaken individual restraint.
  3. No change in the allocation of default losses, since total resources are unchanged.Why not: Ignores that who pays first changes.
  4. Lower cost for all members, since total pre-funded resources are the same.Why not: Ignores the redistribution of costs and incentives; prudent members bear more of the cost.

Total resources are the same, but more of the loss is now borne by other members instead of the defaulter. This is greater mutualisation and more moral hazard.

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