Dr. Jorge Cruz Lopez - Western University, Economics Department

Dr. Jorge Cruz Lopez will be presenting

"Residual Risk and Default Waterfalls in Central Counterparties"

Authors: Jorge Cruz Lopez (University of Western Ontario)

Abstract: I develop a stress-testing methodology to measure residual credit risk exposures and their sources in derivatives central counterparties (CCPs). Residual risks are measured relative to the coverage suggested in the Principles for Financial Market Infrastructures (BIS and CPSS-IOSCO, 2012), which are foundational to global financial regulations since the financial crisis. Residual risks can be used to evaluate the risk management practices of CCPs, their systemic risk contributions, and the effectiveness of regulations mandating the central clearing of over-the-counter (OTC) derivatives. My proposed technique decomposes portfolio profits and risk exposures into two sources: trade crowdedness and asset co-movement. The first source is determined by individual trading decisions that lead to overlapping portfolio weights. The second source is determined by the volatility and co-movement of underlying asset returns. Each source is associated with different market dynamics and requires different policy responses. Even though derivatives portfolios can have highly non-linear profit functions, the proposed technique linearizes the sources of risk exposures without information loss through the use of copulas that allow for counterfactual distributions. Using portfolio-level data from every member in Canada’s largest derivatives CCP from 2003 to 2013, I show that aggregate risk exposures reached record levels during the financial crisis, even though the CCP continued to operate normally. More importantly, the risk decomposition shows that trade crowdedness peaked six months prior to the financial crisis, whereas asset co-movement peaked during and after the crisis. These results suggest that trade crowdedness could serve as a leading indicator of the financial cycle and that it should be considered when designing risk management policies for derivatives portfolios.