CDS Central Counterparty Clearing Liquidation : Road to Recovery or Invitation to Predation?

Recent regulation, mandating the clearing of credit default swaps (CDS) by a Central Clearing Counterparties (CCP), has rendered it's possible failure a serious threat to global nancial stability. This work investigates the potential failure of a CCP initiated by the default of a large dealer bank and the unwinding of its positions. The theoretical model examines variation margin exchange between dealer banks and the price impact of liquidation and predatory selling. It provides a measure of covariance between assets in banks' portfolios; price impact affects assets to varying degrees, based on their relative distance to defaulted assets. Key results show that liquidation lowers CCP profits, and how predation decreases the profits of all members, pushing banks to default. Furthermore, a hybrid CCP (vs. current) structure provides a natural disciplinary mechanism for predation. Also, it is more incentive compatible for the CCP, in expectation of a large loss. A multi-period, dynamic simulation, calibrated to OTC market data, provides parameter sensitivities concerning the magnitude of CCP and predatory bank gains/losses, specifically, the minimisation of those losses with a hybrid fund structure. Furthermore, regulatory implications concerning the timing of liquidity injection for a Lender of Last Resort (LoL) are determined for various liquidity scenarios; stable and decreasing market liquidity, as well as, a liquidity dry-up at the bottom of a financial crisis