Central Counterparty Default Waterfalls and Systemic Loss

Samim Ghamami, Mark Endel Paddrik, and Simpson Zhang

Central counterparty default waterfalls act as the last lines of defense in over-the-counter markets by managing and allocating resources to cover payment defaults. This paper examines the impact of variations in waterfall design on financial system losses in the presence of payment network dependencies and frictions in the cleared and non-cleared portion of the system. Through the development of a structural model, we draw several theoretical conclusions about the effectiveness of CCP default waterfalls under severe payment stress. These findings are empirically quantified by testing the model using supervisory data for the U.S. credit default swap market.