Center for Financial Studies

Goethe-Universitt Frankfurt House of Finance

Grneburgplatz 1 60323 Frankfurt Deutschland


No. 2008/42
Central Counterparties

Thorsten V. Koeppl and Cyril Monnet






Telefon: +49 (0)69 798-30050
Fax: +49 (0)69 798-30077
http://www.ifk-cfs.de E-Mail: info@ifk-cfs.de

Center for Financial Studies
House of Finance Goethe-Universitt
Grneburgplatz 1 60323 Frankfurt am Main Deutschland
Center for Financial Studies
The Center for Financial Studies is a nonprofit research organization, supported by an
association of more than 120 banks, insurance companies, industrial corporations and
public institutions. Established in 1968 and closely affiliated with the University of
Frankfurt, it provides a strong link between the financial community and academia.
The CFS Working Paper Series presents the result of scientific research on selected
topics in the field of money, banking and finance. The authors were either participants
in the Centers Research Fellow Program or members of one of the Centers Research
Projects.
If you would like to know more about the Center for Financial Studies, please let us
know of your interest.
Prof. Dr. Jan Pieter Krahnen Prof. Volker Wieland, Ph.D.
Telefon: +49 (0)69 798-30050
Fax: +49 (0)69 798-30077
http://www.ifk-cfs.de E-Mail: info@ifk-cfs.de
* We are grateful for comments from Charlie Kahn, Jean-Charles Rochet and Jens Tapking and seminar participants at the Bank of
England, the Cass Business School, the CEA meetings, the Bank of Canada, the Econometric Society Meetings, the SED meetings and
the CEPR conference on Competition and Efficiency in Payment and Security Settlement Systems. Furthermore, we thank the Financial
Markets Infrastructure Division at the Bank of England for their hospitality where some of this research was initiated. The usual
disclaimers apply.
1 Queen.s University, Department of Economics Kingston, Ontario, K7L 3N6; e-mial: thor@econ.queensu.ca
2 Federal Reserve Bank of Philadelphia, Research Department, Ten Independence Mall Philadelphia, PA 19106-1574; e-mail:
cyril.monnet@phil.frb.org
CFS Working Paper No. 2008/42
Central Counterparties*
Thorsten V. Koeppl
1
and Cyril Monnet
2
May 28, 2008
Abstract:
Central counterparties (CCPs) have increasingly become a cornerstone of financial markets
infrastructure. We present a model where trades are time-critical, liquidity is limited and there
is limited enforcement of trades. We show a CCP novating trades implements efficient trading
behaviour. It is optimal for the CCP to face default losses to achieve the efficient level of
trade. To cover these losses, the CCP optimally uses margin calls, and, as the default problem
becomes more severe, also requires default funds and then imposes position limits.
JEL Classification: G20, G30.
Keywords: Central Counterparty; Clearing; Default; Collateral; Risk Management.
1 IntroductIon
Sinco lho 1000s. conlial counloipailios (CCIs) hayo Locomo moio ano moio commonplaco
as a coinoislono of lnancial maikol infiasliucluios. Ono iolo of CCIs is lo noyalo conliacls.
In lho noyalion piocoss. lho oiiginal conliacl Lolwoon a Luyoi ano a solloi is oxlinguishoo
ano ioplacoo Ly lwo now conliacls: ono Lolwoon lho Luyoi ano lho CCI. ano anolhoi ono
Lolwoon lho solloi ano lho CCI. Foi oxamplo. cloaiinghousos lhal soiyo as CCI inloiposo
lhomsolyos as lho logal counloipaily foi liaoos caiiioo oul on foimal socuiily oxchangos ano
moio ioconlly also in oyoi-lho-counloi (O1C) maikols.
In assuming iosponsiLilily foi lho loims of lho liaoo CCIs Locomo oxposoo lo :|nnn
:.| - lho oLligalion lo fullll lho loims of a conliacl wilh sollois (iospocliyoly Luyois)
oyon lhough Luyois (iospocliyoly sollois) oofaull on lhoii oLligalions.
1
Noyalion concon-
lialos oofaull iisk in lho hanos of a singlo inslilulion. lho CCI. As a consoouonco. il has
lho polonlial lo oisiupl lnancial maikols if lhis iisk is nol piopoily conliolloo foi.
2
Wo ooyolop a simplo moool of oxchango. whoio common liaoing fiiclions pioyonl inyoslois
lo liaoo omcionlly. Wo show lhal a CCI is a naluial ooyico lo implomonl lho omcionl
loyol of liaoo. 1ho moool foaluios inyoslois wilh a ianoom nooo lo liaoo a socuiily. 1ho
sliucluio of maikols ano piofoioncos of liaoois aio such lhal (i) liaoos hayo lo Lo caiiioo oul
Ly a spocilc limo (i.o.. liaoos aio limo-ciilical). (ii) liaoos cannol Lo fully ano immooialoly
sollloo al lhal limo (i.o.. lhoio is limiloo liouioily) ano (iii) liaoois hayo an oppoilunily
lo ionogo on lhoii oLligalions (i.o.. lhoio is a pioLlom of onfoicing lho loims of lho liaoo).
Wo show lhal lhoso olomonls imposo soyoio limilalions on a ooliyoiy-ys.-paymonl (DyI)
mochanism which can loao lo wolfaio loss. Wo lhon inlioouco a CCI as a lochnology
lhal can holo collaloial ano can commil lo ils piomisos. As such lho CCI is lho iooal
counloipaily ano il aiisos onoogonously in iosponso lo liaoing impoifoclions.
Whilo a CCI onaLlos liaoos. il facos a ioplacomonl cosl iisk sinco il guaianloos lho liaoo
1
Accoioing lo lho Luiopoan Conlial Lank Glossaiy on Iaymonls ano Socuiily. lhis is lho iisk lhal
a counloipaily lo an oulslanoing liansaclion foi complolion al a fuluio oalo will fail lo poifoim on lho
solllomonl oalo. 1his failuio may loayo lho solyonl paily wilh an un-hoogoo oi opon maikol posilion oi
oony lho solyonl paily un-ioalisoo gains on lho posilion. 1ho iosulling oxposuio is lho cosl of ioplacing. al
cuiionl maikol piicos. lho oiiginal liansaclion."
2
Soo Iusso. ol al. (2002). 1ho Commilloo on Iaymonl ano Solllomonl Sysloms (CISS) ioconlly issuoo
inloinalional piinciplos foi CCI iisk managomonl lhal aooioss lho lhioo koy issuos foi conliolling syslomic
iisk in lhis aioa: (i) lho lianspaionl ano piuoonl way of omploying iisk managomonl. (ii) lho oosign of
goyoinanco sliucluios lhal Lalanco lho ioouiiomonls of usois ano lho puLlic inloiosl: (iii) lho polonlial
liaoo-ol Lolwoon omcioncy ano iisk in a silualion of incioasoo compoliliyo piossuio (soo CISS (2004)).
2
againsl oofaull. 1ho CCI conliols ils iisk lhiough collaloial policios. Il can omploy maigin
calls on inoiyioual liansaclions lo socuio ils oxposuio. Il can also ioouiio agonls. inoopon-
oonlly of lhoii liaoing nooos. lo pailicipalo in a oofaull funo. Using lho oofaull funo as an
insuianco pool. lho CCI can mulualizo lossos on liansaclions acioss agonls pailicipaling in
lho CCI. Wo show lhal whon lho oofaull pioLlom is nol soyoio. lho CCI jusl usos maigin
calls. As lho oofaull pioLlom Locomos moio aculo. lho CCI will lhon inlioouco a oofaull
funo on lop of a maigin call ano lhon will uso posilion limils as lho ullimalo lool againsl
oofaull.
1o summaiizo. wo mako lhioo main conliiLulions. Fiisl. wo pioyioo a simplo moool of
oxchango whoio oofaull is an issuo. ano wo show lhal a CCI noyaling liaoos can holp achioyo
liaoing omcioncy. Socono. wo pioyioo an oxplanalion foi lho lhioo main iisk managomonl
lools lhal CCIs uso: oofaull funos. maigin calls ano posilion limils. Finally. wo oxplain
how inyoslois liaoo in spilo of oofaull occuiing in oouiliLiium.
1ho iomainooi of lho papoi is as follows. 1ho noxl soclion lays oul lho Lasic onyiionmonl.
1hon. wo show lhal a CCI is nocossaiy lo oLlain an omcionl loyol of liaoo if liouioily is
limiloo. liaoo is limo-ciilical ano lhoio is limiloo ofoicomonl. Soclion 4 ooiiyos lho oplimal
collaloial policios. Soclion oosciiLos how lo implomonl lho omcionl allocalion. Soclion 6
concluoos.
2 A AodeI oI FInancIaI ExcLange
2.1 TLe EnvIronnent
1ho moool is slalic wilh lhioo suLpoiioos. t = 0. 1. 2 ano a unil moasuio of inyoslois. 1hoio
aio lwo assols cash ano socuiilios in posiliyo supply. Al t = 0. all inyoslois aio onoowoo
wilh an amounl :
0
of cash ano an amounl c
0
of socuiilios. Whoioas cash yiolos a conslanl
pay-ol of 1 poi unil. lho pay-ol of lho socuiily in loims of cash. 0. is ianoom wilh a
cumulaliyo oisliiLulion funclion 1 oyoi a suppoil O = [0. 2[. symmoliic aiouno ils moan
1(0) = 1. All pay-ols fiom lho assols aio ioalizoo al t = 2.
Inyoslois aio iisk-noulial ano yaluo lho pay-ols of lho socuiily ano cash ioonlically. How-
oyoi. lhoy faco an uncoilain cosl of holoing lho socuiily. 1hoio aio lhioo lypos of inyoslois.
lhal wo laLol as /. / ano :. whoio / lypos onjoy a Lonoll c (0. 1[ fiom holoing lho socuii-
lios. / lypos suloi a cosl c fiom holoing socuiilios ano : lypos gol no cosl oi Lonoll fiom
holoing socuiilios so lhal c
c
= 0. A fiaclion : of inyoslois is of lypo :. whoioas an ooual
8
fiaclion (1 :)2 of inyoslois is of lypo / ano /. Al t = 1. inyoslois loain lhoii lypo ano il
is piiyalo infoimalion. Upon liaoing ano onco lho socuiily`s payol is ioalizoo. inyoslois of
lypo i /. /. : onjoy ulilily n
j
. fiom holoing cash : ano socuiilios c which oouals lo
n
j
(:. c: c
j
) = : (0 c
j
)c.
whoio c
j
oxpiossos lho ioalizoo holoing cosl foi inyosloi i.
Wo lako as giyon lhal al t = 1 afloi lho holoing cosl of inyoslois is known lhoio is
a compoliliyo maikol whoio inyoslois can liaoo lho socuiily. Lul aio nol allowoo lo soll
lho socuiily shoil. In lho conloxl of lho lnancial maikols infiasliucluio. wo inloipiol lhis
sol-up as follows. Inyoslois aio momLois of an oxchango liaoing an assol (such as slocks)
oi moio gonoially a lnancial conliacls (such as fuluios) on lhoii own Lohalf oi foi lhoii
cuslomois.
8
1ho nooo lo liaoo lho conliacl is oxpiossoo as lho holoing cosl of lho socuiily
which giyos an inliinsic Lonoll fiom Luying oi solling lho conliacl. 1his coiiosponos lo
lho nooo lo lako a pailiculai posilion in oiooi lo hoogo somo iisk oi lo aojusl a liouioily
posilion among olhois. Wo laLol inyoslois wilh such a nooo lo liaoo as ]&nJnnnn| :nJ:.
Olhoi inyoslois aio inoiloionl al lho limo of liaoo Lolwoon Luying oi solling lho socuiily.
1o lho oxlonl lhal lhoy aio willing lo lako a posilion whon liaoing occuis. lhoy pioyioo
liouioily lo lho maikol oi liy lo oxploil a mispiicing of lho lnancial assol oi conliacl. Wo
lhus call lhoso inyoslois &|n:.
1hoio aio lhioo assumplions on liaoing socuiilios in lhis oconomy. Fiisl. whilo cash can Lo
liansfoioo in any poiioo. lho socuiily log of any liaoo in poiioo t = 1. can only Lo sollloo
in poiioo 1. 1his oolay in solllomonl of a liansaclion wilh a paymonl in cash iolocls lho
facl lhal on lnancial maikols lho fioouoncy of liaoing is oflon much highoi lhan lho ono of
sollling liansaclions. 1his foaluio iulos oul a spol liaoo on lho Lasis of ooliyoiy-ys-paymonl
(DyI). Socono. whilo liaoing occuis in a conlializoo Waliasian maikol. liaoos aio Lolwoon
pailiculai inyoslois. i.o. n |nn lhoio is a singlo. woll oolnoo. Luyoi lo oach solloi
ano inyoisoly. Lasl. wo assumo lhal lhoio is limiloo commilmonl in lho oconomy. i.o. il is
impossiLlo lo (fully) onfoico .n:n:n| liaoos. In pailiculai. inyoslois cannol commil
lo giyo up oilhoi socuiilios oi cash al a laloi slago lo lhoii iospocliyo counloipaily of lho
liaoo. Oui lisl assumplion implios lhal any liaoo among inyoslois occuis al t = 1. Lul
8
Oui pailiculai assumplions on lho supply ano payol sliucluio of lho socuiily aio laigoly iiioloyanl foi
oui iosulls as long as lhoio is a Louno on shoil solling. 1his implios lhal oui sol-up ooos nol coiiospono lo
a pailiculai lnancial insliumonl oi maikol. Lul lo a gonoial maikol foi liaoing (any) assols compoliliyoly
wholhoi on a conlializoo oxchango oi in lho O1C maikol pioyiooo lhoio is sumcionl compolilion among
counloipailios.
4
musl Lo sollloo in t = 2 afloi lho pay-ol of lho socuiily has Loon ioalizoo. ComLinoo wilh
a lack of commilmonl. il implios lhal inyoslois can oofaull.
2.2 EucIent AIIocatIons
1ho pioLlom in lhis oconomy is lo iooisliiLulo lho socuiily ano cash among inyoslois onco
lhoii holoing cosls hayo Loon ioalizoo. An allocalion (c
j
. :
j
)
jI..c
is a oisliiLulion of
lho socuiily ano cash acioss lho oiloionl lypos of inyoslois. Il is cloaily omcionl lo liansfoi
socuiilios fiom low lypo liaoois ano spoculalois lo high lypo liaoois haying a Lonoll fiom
holoing lho socuiily. 1ho omcionl oisliiLulion of cash :

is inooloiminalo as all inyoslois

yaluo il lho samo way. 1ho omcionl allocalion is lhon oolnoo Ly c

I
= 2c
0
(1 :). c

= 0
ano c

c
= 0. 1his allocalion yiolos oxpocloo wolfaio as of t = 1 ooual lo
\(c

. :

) = :
0
(1 c)c
0
.
as all socuiilios aio holo Ly liaoois wilh a holoing Lonoll c.
3 Trade and DeIauIt
1ho omcionl allocalion woulo Lo foasiLlo if agonls coulo wiilo fully onfoicoaLlo conliacls.
Howoyoi. wo now show lhal oui assumplions imply lhal oofaull is an issuo ano lhal il
unoouiyocally lowois wolfaio.
Wilh a piico j foi lho socuiily in lho Waliasian maikol. lho Luogol consliainl foi all
inyoslois al t = 1 is giyon Ly
:
j
jc
j
:
0
jc
0
.
Sinco lho oxpocloo ulilily of all inyoslois is sliiclly incioasing in socuiilios oi cash. oi Lolh.
lhoii Luogol consliainl always Linos. Honco. wo hayo lhal
j (c
j
c
0
) = :
0
:
j
. (1)
Consiooi now lho inconliyos lo solllo a liansaclion al t = 2. Inyoslois oo nol hayo an
inconliyo lo oofaull on a liaoo as long as lho following n-J]n&| n:n.n aio fulllloo
:
j
(0 c
j
)c
j
:
0
(0 c
j
)c
0
.
oi
(0 c
j
) (c
j
c
0
) :
0
:
j
. (2)

Compaiing (1) ano (2). wo lno lhal spoculalois will oofaull whon lhoy aio Luyois ano 0 < j.
oi whon lhoy aio sollois ano 0 j. Also. as high funoamonlal liaoois aio Luyois whilo low
funoamonlal liaoois aio sollois in any oouiliLiium. lhoy hayo an inconliyo lo oofaull only
if. iospocliyoly
0 c < j
ano
0 c j. (8)
Honco. liaoos Lolwoon funoamonlal liaoois will only solllo if 0 [jc. jc[. Whoioas lho
holoing cosl giyos a moliyo foi liaoo. il also moliyalo lho inconliyos foi oofaull. Funoamonlal
liaoois howoyoi oofaull if lho payol of lho socuiily moyos loo fai away fiom lho liaoing
piico. Fuilhoimoio. lho lowoi lho holoing cosl. lho laigoi lho polonlial foi oofaull. As c
appioachos zoio. no liaoo woulo Lo sollloo.
IroposItIon 1. nn.nn . |.n.J. h: . n :nJ .n n&.|.h:.&n n t = 1 &.h&
n .. :hnh.|.j ] J]n&| .n :.J t = 2.
Whonoyoi oofaull occuis. a liaoo will nol solllo ano lho lwo liaoois koop lhoii onoowmonls
(:
0
. c
0
). Honco. in lho caso of oofaull. lho liaoing pailios oLlain ulilily
:
0
(0 c
j
)c
0
Nolico lhal as oofaull olois an oplion yaluo lo spoculalois. lhoy will always lako a posilion
whon liaoing occuis al t = 1. 1his implios lhal all funoamonlal liaoois faco a posiliyo
pioLaLilily lhal lhoii liaoo will nol solllo. In caso lho liaoo of a high (oi a low) liaooi ooos
nol solllo. lho wolfaio loss is piopoilional lo lho holoing cosls. Foi oxamplo. lho suiplus
gonoialoo fiom a paii of liaoois (/. /) is :
I
(0 c) c
I
:

(0 c) c

. whoio foasiLily
ioouiios lhal :
I
:

= 2:
0
ano c
I
c

= 2c
0
. If lho spoculaloi oofaulls. lho suiplus fiom
lho liaoo is :
0
(0 c) c
0
:
0
(0 c) c
0
. which implios a wolfaio loss of c (c
I
c

) 0.
In woios. lho wolfaio implicalions of oofaull play lhiough holoing cosls. Spoculalois Loai
no wolfaio cosls fiom oofaull. whilo funoamonlal liaoois hayo a ulilily loss whonoyoi lhoy
cannol solllo lhoii liaoo. Inyoslois wilh high holoing cosls ono up holoing lho socuiily.
whilo pooplo wilh low holoing cosls holo on lo cash. In conclusion. nnj oofaull incuis a
wolfaio loss.
4
4
Foi a funoamonlal liaooi lhal is a Luyoi. lho liaoo will solllo if lho counloipaily is a low lypo ano
0 j c. j c oi if 0 j c. j. Honco. lho wolfaio loss poi high lypo is giyon Ly
cq

q 1j c 1j1vo/cc||cv /cc||cv 1j 1j c .
A similai conoilion holos foi funoamonlal liaoois lhal soll lho socuiily.
6
IroposItIon 2. 1]n&| |&: rJ &|]n:.
4 Trade and CoIIateraI
1ho lasl iosull is impoilanl as il giyos a ioason lo oliminalo. oi al loasl iosliicl. oofaull.
Sinco wo sluoy a slalic onyiionmonl. iopulalion cannol oampon lho inconliyos lo oofaull.
Honco. wo sluoy lisl collaloial ioouiiomonls. 1o analyzo which allocalions is foasiLlo wilh
collaloial. wo sol up a planning pioLlom lhal lakos lho Waliasian liaoing mochanism. as
woll as lho liaoing fiiclions as giyon. 1ho plannoi oLjocliyo is lo maximizo lho oxpocloo
wolfaio of inyoslois al t = 1.
1ho plannoi opoialos a ||n:n| ]n.|.j lhal socuios liaoos wilh collaloial. Wo assumo
lhal sloiing collaloial al lho facilily ooos nol inyolyo any cosl. 1ho plannoi lhoiofoio has
lho oplion lo iocoiyo. sloio ano oisLuiso cash foi solllomonl. Sinco lho omcionl alloca-
lion ioouiios lhal high lypos gol all lho socuiilios. lho plannoi nooos lo giyo inconliyos lo
spoculalois lo liaoo away lhoii socuiily. Honco. wo assumo lhal inyoslois oo nol iocoiyo
any cash Lack if lhoy oo nol liaoo. Sinco collaloial is ploogoo Lofoio lypos aio ioyoaloo.
spoculalois will always lako a posilion. oilhoi as Luyois oi sollois. Wo oonolo Ly (n
I
. n

)
lho solllomonl Lalancos ooponoing on wholhoi inyoslois Luy oi soll lho socuiily. FoasiLilily
oLyiously ioouiios lhal lho sum of all solllomonl Lalancos. n
0
. is smalloi lhan lho oyoiall
posloo collaloial. Giyon posling collaloial is coslloss. il is ouilo cloai lhal lho inconliyos
lo oofaull aio minimizoo whon lho plannoi ioouiios an amounl :
0
of collaloial fiom all
liaoois. ano wo will lhoiofoio assumo lhal lhis is lho caso fiom now on. Wo also assumo
lhal lho plannoi can imposo ..n |.n.. which iosliicl lho sizo of lho inyoslois` liaoos.
Ly ilsolf. a collaloial facilily ooos nol pioyonl oofaull ano wo nooo lo spocify lho plannoi`s
oplions whon lhoio is oofaull. In lhis caso. wo assumo lhal inyoslois loso all lhoii collaloial
lo lho collaloial facilily. 1ho facilily has lhon lwo souicos of funos lo coyoi lho loss of a
oofaull. Il can uso lho soizoo collaloial. ano il can also uso lho shaio of lho collaloial lhal
is nol ploogoo lo solllo liaoo. i.o. lho woighloo sum of :
0
n
j
. 1ho facilily usos lhoso
iosouicos lo acouiio lho socuiily foi ils ioalizoo yaluo 0 ano liansfois il lo lho counloipaily
lhal suloioo lho oofaull. Wo iulo oul lhal lho collaloial facilily ilsolf can oofaull on lhis
guaianloo. In whal follows. wo laLol lho collaloial facilily as n:n| &n:n:j oi CCI.
Wilh a CCI. lho liming of oyonls is lho following. Al t = 0. lho plannoi ioouosls lho
liansfoi of cash :
0
as collaloial which is cosllossly sloioo unlil t = 2. 1hon. al t = 1. lho
inyoslois` lypo is ioalizoo. Al lhis slago. lho collaloial facilily assigns solllomonl Lalancos
7
Settlement stage
realized
announced
Trade
realized
Default
CCP buys securities
Settlement
Collateral transfer
to CCP
0
m
) , (
"
w w
h
Trading stage Collateral stage
i

Figuio 1: 1imolino.
(n
I
. n

) lo Luyois ano sollois iospocliyoly. Il can also sol posilion limils. which iosliicl
lho sizo of lho inyoslois` liaoos. 1akon lhis collaloial policy as giyon. inyoslois liaoo on a
poifoclly compoliliyo Waliasian maikol. Finally. al t = 2. afloi lho payol 0 of lho socuiily
has Loon ioalizoo. inyoslois oilhoi uso lhoii Lalancos lo solllo lhoii liaoos oi oofaull. If
oofaull occuis. lho CCI usos ils ayailaLlo iosouicos lo coyoi oofaulloo liaoos. Figuio 1
summaiizos lho sol-up.
4.1 HIsk Aanagenent VItL o Aggregate DeIauIt HIsk
4.1.1 o DeIauIt vItL SuucIent CoIIateraI
As long as inyoslois hayo sumcionl collaloial :
0
lo coyoi lho oofaull oxposuio fiom liaoing.
posling collaloial can iulo oul oofaull. Giyon an allocalion (:
j
. c
j
). ano haying ploogoo :
0
as collaloial. inyoslois oo nol oofaull as long as
:
j
(0 c
j
)c
j
(0 c
j
)c
0
foi all 0 O. Luyois of lho socuiily will noyoi oofaull as :
I
0 ano c
I
c
0
. In oouiliLiium
high lypo liaoois will only Luy socuiilios as lhoy onjoy holoing Lonolls. Also. sinco low
lypo liaoois incui lho cosl of holoing socuiilios. lhoy hayo loss inconliyo lo oofaull lhan
spoculalois who solo socuiilios. Honco. oofaull is iuloo oul whonoyoi spoculalois oo nol
oofaull. oi whon
:

0c
0
foi all 0 O. whoio wo hayo consiooioo lho laigosl salo c

= 0. Honco. wo hayo lho following

iosull.
Lenna 3. 1] :
0
c
0
. h: . &.n ||n:n| :&| & J]n&|.
8
1:]. Fiom lho Luogol consliainl of spoculalois. wo hayo lhal
:

= jc
0
n

(4)
whoio n

is lho Lalanco associaloo wilh solllomonl foi sollois. Sol n

I
= n

= :
0
. Wo lisl
show lhal j < 1 is nol an oouiliLiium. If j < 1. all spoculalois Luy socuiilios ano lhoiofoio
oo nol hayo an inconliyo lo oofaull. Howoyoi. in lhis caso. all Luyois spono all lhoii cash
so lhal fiom lho maikol cloaiing conoilion. il musl Lo lho caso lhal
(1 :)
2
jc
0
= ::
0

(1 :)
2
:
0
.
1his is oouiyalonl lo
jc
0
=
(1 :)
(1 :)
:
0
.
Howoyoi sinco wo assumo :
0
c
0
. lhis conliaoicls lho facl lhal j < 1. Now assumo j 1.
1hon spoculalois aio willing lo soll lho socuiily ano wo hayo
:

c
0
:
0
2c
0
. ()
Whonoyoi lhoio is sumcionl collaloial. lho CCI can iulo oul oofaull .nJnJn of 0. In
lhis sonso. lhoio is no aggiogalo oofaull iisk in lho oconomy whonoyoi :
0
c
0
. Whon lhoio
is no iisk of oofaull. lho CCI also ooos nol nooo lo iosoil lo posilion limils lo iosliicl liaoo.
4.2 ConstraIned EucIent AIIocatIons VItLout DeIauIt
Supposo now lhal :
0
c
0
ano lhal lho iisk managomonl policy of lho CCI iulos oul
oofaull al t = 2. If possiLlo. lho CCI choosos lo oisliiLulo solllomonl Lalancos n
j
so lhal
low lypos ano spoculalois soll as many socuiilios lo high lypos. Sinco inyoslois aio iisk
noulial lhoy will lako oxliomo posilions. 1hoy oilhoi will soll all lhoii socuiilios (c

= 0) oi
spono all lhoii solllomonl Lalanco lo Luy socuiilios (:
I
= 0). Any allocalion (:
j
. c
j
) lhal
lho CCI wanls lo achioyo has lhon lo salisfy lho following inconliyos consliainls
(1(0) c)c
I
= (1 c)c
I
:

. (6)
(1(0) c)c
I
= (1 c)c
I
< :

. (7)
in aooilion. spoculalois will soll socuiilios if 1(0)c
I
= c
I
< :

ano Luy olhoiwiso. If

lho lalloi conoilion holos wilh ooualily. spoculalois aio jusl inoiloionl Lolwoon laking any
0
posilion. Honco. whon c is lho fiaclion of spoculalois solling lho socuiily. wo hayo
c =

1 if c
I
< :

.
[0. 1[ if c
I
= :

.
0 if c
I
:

.
(8)
1o iulo oul oofaull. spoculalois shoulo nol oofaull foi any ioalizalion of 0 whon lhoy soll
lho socuiily. in pailiculai foi 0 = 2. Honco lho plannoi facos lho consliainl
:

2c
0
if c 0. ano (0)
:

(2 c) c
0
if c = 0. (10)
Finally. lho maikol cloaiing conoilions aio lhon giyon Ly

1 :
2
c:

= n
0
. (11)

1 :
2
(1 c):

c
I
= c
0
. (12)
All allocalions lhal salisfy inooualilios (6)-(10) ano maikol cloaiing conoilions (11) ano
(12) oo nol inyolyo oofaull ano aio foasiLlo foi lho CCI. Nolo lhal lhoso conoilions salisfy
lho ioouiiomonl lhal liaoos lako placo on a compoliliyo maikol. Also nolo lhal lho oxacl
allocalion of solllomonl Lalancos only mallois lo lho oxlonl lhal il inoucos inyoslois lo lako
a pailiculai (oxliomo) posilion of Luying oi solling socuiilios ano pioyonling oofaull.
Duo lo linoaiily. as long as lho Luogol consliainls aio salisloo ano lho piico falls in lho
inloiyal [1 c. 1 c[. lho loyol of solllomonl Lalancos n
j
is inooloiminalo. ano lho way
solllomonl Lalancos aio iooisliiLuloo only impacl lho oouiliLiium piico.

Slill. il is oplimal
lhal lho CCI ioluins all cash :
0
foi solllomonl. so lhal wo can sol n
0
= :
0
.
1ho allocalions lhal aio foasiLlo foi lho CCI aio lhon summaiizoo Ly lhioo conoilions. 1ho
lisl ono onsuios funoamonlal liaoois lako on lho iighl posilion
(1 c)
1 (1 2c):
1 (1 2c):
:
0
c
0
1 c. (18)
1ho socono ono oosciiLos liaoing Ly spoculalois ano is giyon Ly
c =

1 if
1a
1a
c
0
:
0
1
2

1
1
a
n

if c
0
< :
0
<
1a
1a
c
0
1
2
if c
0
= :
0
.
(14)

1his is iolaloo lo lho socono wolfaio lhooiom. A solloi`s Luogol consliainl yiolos i

jq n

whilo a
Luyoi Luogol consliainl giyos q

qn

j. Honco. giyon j c. c. lhoio oxisls a paii n

. n

such
lhal lho Luogol consliainls aio salisloo. Nolico lhal lho paii has also lo salisfy lho foasiLilily consliainl.

cn

c n

i.
10
Nolico in pailiculai lhal c 12 lo salisfy lho maikol cloaiing conoilions. Finally. oofaull
is iuloo oul as long as
:
0
c
0
1 (1 2c):. (1)
1ho CCI woulo liko lo maximizo lolal oxpocloo wolfaio as of t = 1. Sinco inyoslois aio iisk
noulial wilh iospocl lo cash. only lho holoing cosls fiom allocaling lho socuiily malloi. 1o
soo lhis. nolo lhal. afloi somo manipulalions. lho oLjocliyo funclion is giyon Ly
:
0
1(0)c
0

1 :
2
c (c
I
c

) .
Using c

= 0 ano maikol cloaiing. afloi noglocling conslanls lhis is oouiyalonl lo choosing

c lo maximizo
1
1 (1 2c):
suLjocl lo lho iosliiclions (18)-(1) aLoyo. Cloaily. lho plannoi woulo liko lo hayo as many
spoculalois soll lho socuiily as possiLlo (oi c as closo lo 1). Maikol cloaiing. inconliyos
lo liaoo ano lho oofaull pioLlom imposo iosliiclions on lho allocalion ho can achioyo. Wo
lhon oLlain lho following iosull.
IroposItIon 4. 1] :
0

1a
1a
c
0
. h 1 nh. h ]:-h n||n.n hj :n&.:.nn
||n:n| :
0
nnJ n|| &|n: || &:.. c = 1. 1] :
0
[c
0
.
1a
1a
c
0
). h 1 nh.
h n:n.nJ .n n||n.n c
I
= c
0
:
0
. c

= 0 nnJ n &|n: h&j &:..

c < 1. 1&:h:n:. . . n|&nj .n :&| & J]n&| .n n&.|.h:.&n.
1:]. Foi lho lisl caso. sol c = 1. 1ho no oofaull consliainl is fulllloo. as
:
0

1 :
1 :
c
0
(1 (1 2c):)c
0
as : (0. 1). Also. lho conoilion lhal :
c||
c
I
is salisloo sinco :
0

1a
1a
c
0
. Supposo
lhal (1 c)
1a
1a
n

. 1hon. lho liaoing conoilion on funoamonlal liaoois is also salisloo.

If (1 c)
1a
1a
n

. wo can slill achioyo lho samo allocalion Ly allowing high lypos lo hayo
somo cash :
I
= :
0
(1 c)
1a
1a
c
0
0.
Foi lho socono caso. as :
0

1a
1a
c
0
is nol salisloo. wo can`l sol c = 1. Howoyoi lho
conoilion foi c (0. 1) giyos us lho yaluos foi c. ano al c =
1
2

1
1
a
n

. wo hayo lhal
1 (1 2c): = 1
:
0
c
0
:
0
c
0
=
2c
0
:
0
c
0

:
0
c
0
so lhal lhoio is no oofaull. As c 0 ano
1(12c)a
1(12c)a
n

= 1. lho liaoing conoilion is also

fulllloo.
11
Foi lho lasl slalomonl. supposo lhal all spoculalois soll lho socuiily (c = 1) which coulo
only happon in an oouiliLiium wilh oofaull. 1ho foasiLilily conoilion foi solllomonl Lalancos
lhon Locomos
:

1 :
2
:

1 :
2
:

1 :
2
(1 :)

n
I
< :
0
. (16)
whoio lho lasl inooualily holo as lho CCI nooos lo socuio iosouicos lo coyoi oofaull lossos.
Foi spoculalois lo hayo an inconliyo lo soll. wo nooo :

c
I
. 1hus.
c
I
:

<
2
1 :
:
0
. (17)
Honco. Luyois can oLlain al mosl
2
1a
:
0
which is loss lhan c
0
:
0
. A conliaoiclion.
1ho CCI woulo liko lo liansfoi as many socuiilios as possiLlo lo high lypos. 1o lhis ono.
il nooos lo onsuio lhal spoculalois aio nol sollois of socuiilios wilhoul ciowoing oul salos
Ly low lypos. In any oouiliLiium wilhoul oofaull. as long as lhoio is onough cash (:
0

(1 :) c
0
(1 :)). lho CCI can inouco all spoculalois lo soll lho socuiily. Olhoiwiso.
lhoio can Lo al mosl a fiaclion c < 1 of spoculalois lhal solls lho socuiily. Iuling oul
oofaull Ly ioouiiing sumcionl collaloial is always omcionl.
Wo now sluoy lho caso whoio collaloial is scaico. :
0
< c
0
. ano ooiiyo lho oplimal alloca-
lion whon lhoio is no oofaull in oouiliLiium. 1ho plannoi lhon facos lho following sol of
consliainls. Fiisl lho plannoi facos a no oofaull consliainl foi spoculalois ano funoamonlal
inyoslois. As Lofoio. only lho oofaull consliainl foi spoculalois is lho Linoing consliainl
ano sinco 0
nnx
= 2. wo can wiilo lhis consliainl as
:

2c

2c
0
. (18)
Socono. lho plannoi facos lho pailicipalion consliainl oiclaling lhal spoculalois aio al loasl
inoiloionl lo soll lhoii socuiilios lo high lypos.
:

c
I
(10)
wilh ooualily of c (0. 1). whoio wo hayo usoo lho facl lhal high lypos spono all lhoii cash
on Luying socuiilios. Finally. lho plannoi facos maikol cloaiing conoilions giyon Ly

1 :
2
c:

= n
0
. (20)

1 :
2
(1 c):

c
I

1 :
2
c:

= c
0
. (21)
12
Fiom lho pioyious pioposilion. wo concluoo lhal c < 1. so lhal (10) Linos. 1hon comLinoo
logolhoi wilh (21) ano lhon (20). wo oLlain
c
I
= c
0
n
0
c

= c
0

1 (1 2c) :
1 (1 2c) :
n
0
As Lofoio. wolfaio is piopoilional lo c
I
c

. so lhal solling n
0
= :
0
is oplimal. ano lhon
c
I
c

=
2
1 (1 2c) :
:
0
.
Honco. lho plannoi will sol c as low as possiLlo. Howoyoi. il is consliainl Ly (18). Using
lho yaluos foi :

ano c

. lhis simplilos lo c 12. 1hoiofoio. lho plannoi oplimally sols

c = 12. so lhal wolfaio is piopoilional lo 2:
0
. Wo summaiizo lhis ooiiyalion in lho
following pioposilion.
IroposItIon 5. 1] :
0
< c
0
. h h n||n.n &.h n J]n&| . c
I
= c
0
:
0
. c

= c
0
:
0
.
nnJ c = 12.
In Figuio 2. wo show c

. c ano lho wolfaio poilion oiiginaling fiom lho oxchango of lho

socuiily. c
I
c

. as a funclion of lho ayailaLlo liouioily :

0
. Nolico lhal whilo lho oopicloo
allocalion foi :
0
c
0
is oplimal. lhis may nol lho caso foi lho no-oofaull allocalion whon
:
0
< c
0
. as wo will show Lolow.
4.3 HIsk Aanagenent vItL Aggregate DeIauIt HIsk
If sollois hayo an oplion lo oofaull. lho CCI musl sol aggiogalo solllomonl Lalancos Lolow
:
0
(i.o. a oofaull funo). In lhis way. il insuios onough iosouicos lo fullll ils piomisos
lo solllo in caso of oofaull. 1his implios. howoyoi. lhal lho puichasing powoi of Luyois
oocioasos oi. oouiyalonlly. lhal c
I
< c
0
:
0
. Wo now ioonlify lho omcionl inslilulional
foaluios of iisk managomonl foi lho cloaiing of lnancial liaoos whon lhoio is insumcionl
collaloial lo pioyonl oofaull.
4.3.1 DeIauIt vItL InsuucIent CoIIateraI
Wo inlioouco oofaull iisk foi lho oconomy oyon wilh a collaloial facilily. 1o Luilo up somo
inluilion foi lho following soclion. wo lisl imposo c

= 0. so lhal sollois liaoo all lhoii

socuiilios away. ano ooiiyo pioliminaiy iosulls on oofaull. Wo know fiom lho pioyious
18
Figuio 2: No oofaull allocalions. c
0
= 1.
soclion. lhoio is nol onough collaloial lo iulo oul oofaull if inyoslois lako oxliomo posilions
whon :
0
c
0
. 1ogolhoi wilh c

= 0.
:

0c
0
foi all 0 O. iulos oul oofaull of spoculalois lhal soll lho socuiily. As Lofoio. lhis implios
lhal low lypo liaoois oo nol oofaull oilhoi. Howoyoi. consiooiing spoculalois` inconliyos
foi liaoo. lhoio cannol Lo liaoo wilhoul oofaull. 1his is oui noxl pioliminaiy iosull.
6
Lenna 6. 1 :
0
< c
0
nnJ c

= 0. 1] &|n: n: ||.nn h &:.j n|| :nJ .n|

n .. :hnh.|.j ] J]n&| ]: n 0 O = [0. 2[.
1:]. Fiisl nolo lhal sollois only hayo an inconliyo lo soll socuiilios if :

c
I
. Supposo
lhoio is no oofaull. Fiisl lol :

c
I
. 1hon. c = 1 as all spoculalois soll lho socuiily.
1hon. as :
0
< c
0
. wo hayo lhal :

=
2
1a
:
0
< 2c
0
= 0
nnx
c
0
. which is a conliaoiclion.
Now lol :

= c
I
. 1his implios lhal c is giyon Ly
2
1 (1 2c):
:
0
=
2
1 (1 2c):
c
0
(22)
6
Foi lho sako of complolonoss. afloi lhis iosull. wo shoulo slill yoiify wholhoi lho allocalion whoio all
spoculalois aio liaoing is oominaloo Ly an allocalion whoio somo spoculalois aio nol liaoing. Howoyoi. a
momonl ioloclion shoulo conyinco lho ioaooi lhal lhis is likoly nol an oouiliLiium. as spoculalois woulo
foiogo lho oofaull oplion if lhoy oo nol liaoo.
14
so lhal c < 12. Honco. :

= c
I
=
2
1(12c)a
c
0
<
2
1a
c
0
< 0
nnx
c
0
which again is a
conliaoiclion.
Wo also show lhal funoamonlal sollois also hayo an inconliyo lo oofaull if c is small ano
c

= 0. Foimally wo oLlain
Lenna 7. 1 :
0
< :(c) < c
0
nnJ c

= 0. 1&nJnnnn| ||: J]n&| ]: n 0

0 (c).
1:]. Giyon c

= 0. lho payol of funoamonlal sollois is :

. Using lho maikol cloaiing

conoilion (11). :

is ooual lo 2n
0
(1 : 2c:). whoio n
0
:
0
. Cloaily. solling n
0
= :
0
minimizos lho inconliyos lo oofaull. Howoyoi. funoamonlal sollois piofoi lo oofaull whonoyoi
(0 c) c
0

2:
0
(1 : 2c:)
.
Sinco c [0. 1[. funoamonlal sollois oofaull whonoyoi
0
2
(1 :)
:
0
c
0
c

0 (c) .
Nolico lhal

0 (c) < 0
nnx
= 2. whon :
0
c
0
< (2 c) (1 :) 2. Honco. funoamonlal sollois
oofaull whonoyoi :
0
< :(c). oolnoo as
:(c)
(2 c) (1 :)
2
c
0
.
In pailiculai. if c = 1. funoamonlal spoculalois will oofaull on an allocalion wilh c

= 0.
foi somo 0. whon :
0
< (1 :) c
0
2.
Wo mako lwo facililaling assumplions. Fiisl. lho CCI inoucos (somo) spoculalois lo soll
lho socuiily ano all spoculalois lo liaoo. Socono. 0 is unifoimly oisliiLuloo oyoi lho inloiyal
[0. 2[.
4.3.2 ConstraIned EucIent AIIocatIons vItL DeIauIt
1ho CCI woulo liko lo liansfoi as many socuiilios as possiLlo fiom low lypos ano spoculalois
lo high lypos. Wo alioaoy showoo lhal whonoyoi 0 is loo high. lhoio is a iisk of oofaull.
loaoing lo a misallocalion of socuiilios. 1hoio aio lwo ways foi lho CCI lo iomooy lhis
pioLlom. Fiisl. il coulo imposo posilion limils on lho salo of lho socuiily. implying a
minimum amounl of socuiilios holoings foi low lypo liaoois. c

c 0. Socono. il coulo
only ioluin n
0
< :
0
lo inyoslois foi solllomonl puiposos. using lho iomainooi :
0
n
0
lo
1
puichaso lho socuiily al t = 2 al a piico ooual lo lho ioalizoo pay-ol 0. ano liansfoi lo lho
Luyoi whoso counloipaily oofaulloo.
Cloaily. lhoio musl Lo sumcionl funos ayailaLlo lo coyoi lho oofaull iisk foi all ioalizalions
of 0. 1hoio aio lwo casos lo consiooi. 1ho lisl lho caso occuis whon :
0
:. oolnoo
aLoyo. 1hon funoamonlal sollois noyoi oofaull. Howoyoi. spoculalois who solo socuiilios
mighl oofaull. 1hal is. whonoyoi c 0 ano :
0
:. lho CCI facos lho following Luogol
consliainl
:
0
(1 c:) n
0
c:0
nnx
(c
0
c

) = 2c:(c
0
c

). (28)
If lhoio is oofaull. lho CCI conlscalos lho collaloial of lhoso c: spoculalois who oofaull.
Howoyoi. il slill nooos lo liansfoi n
0
lo lhoso who oo nol oofaull. Honco. lho CCI has
:
0
c:n
0
n
0
ayailaLlo lo coyoi lho woisl possiLlo loss. 1his loss occuis al lho Losl
pay-ol foi lho socuiily ano is ouo lo all spoculalois who solo socuiilios up lo lho polonlial
posilion limil c
0
c

. Whon c = 0. lhoio is noyoi oofaull. ano lho plannoi ooos nol nooo
lo socuio funos.
1ho socono caso is whon :
0
< :. 1hon Lolh spoculalois ano funoamonlal sollois mighl
oofaull. 1hon lho CCI facos lho following Luogol consliainl insloao of (28):
:
0
(1 (1 2c) :)
n
0
2
(1 (1 2c) :) (c
0
c

). (24)
Wo piocooo as in lho pioyious soclion. 1ho CCI has lo mainlain lho inconliyos foi liaoo.
High lypos Luy ano low lypos soll lho socuiily as long as
(1(0) c) (c
I
c

) = (1 c) (c
I
c

) :

(1(0) c) (c
I
c

) = (1 c) (c
I
c

) < :

Hoio wo hayo lakon inlo accounl lhal (i) low lypos liaoois oo nol oofaull whon solling lhoii
socuiilios ano (ii) lhal high lypos liaoois can always solllo lhoii liaoo oilhoi wilh lho sollois
of lho socuiily oi lho CCI. as (28) guaianloos. Also. as solllomonl is guaianlooo foi Luyois.
lhoy will spono all lhoii solllomonl Lalancos on Luying socuiilios so lhal :
I
= 0. Noxl. wo
hayo lho lwo maikol cloaiing conoilions which aio now giyon Ly

1 :
2
c:

= n
0
(2)

1 :
2
(1 c):

c
I

1 :
2
c:

= c
0
. (26)
1hoio is now loss cash ayailaLlo foi lho CCI lo oisliiLulo as solllomonl Lalancos foi in-
yoslois` liaoo. as lho CCI has lo coyoi ils oxposuio againsl oofaull. Honco. lolal cash
16
Lalancos foi liaoing n
0
aio all holo Ly sollois in oouiliLiium. Fuilhoimoio. whonoyoi lho
CCI imposos posilion limils. sollois cannol soll all lhoii socuiilios.
Finally. wo hayo lo lako inlo accounl lhal spoculalois hayo an inconliyo lo liaoo. As lhoy
can oofaull if lho socuiily pay-ol is sumcionlly high. lhoy hayo an oplion yaluo of oofaull.
whilo lhoy onjoy guaianlooo solllomonl lhiough lho CCI whon Luying lho socuiily. Honco.
spoculalois will Lo inoiloionl Lolwoon Luying oi solling lho socuiily as long as
1(0)c
I
=

maxc

0 :

. 0c
0
d1(0) (27)
1ho iighl-hano sioo lakos inlo accounl lhal spoculalois who soll lho socuiily oofaull whon-
oyoi
0
:

c
0
c

.
Sinco wo hayo assumoo lhal c is laigo onough. funoamonlal liaoois will always hayo an
inconliyo lo liaoo. 1aking inlo accounl lhal 0 is unifoimly oisliiLuloo. wo can iowiilo lho
inoiloionco conoilions foi spoculalois (27) lo oLlain
:

= 2

(c
I
c
0
)(c
0
c

). (28)
Iowiiling lho maikol cloaiing conoilion foi socuiilios (26). wo oLlain
c
I
c
0
=
1 (1 2c):
1 (1 2c):
(c
0
c

). (20)
Finally. wo hayo lo chock wholhoi spoculalois hayo an inconliyo lo liaoo ialhoi lhan nol
which is oouiyalonl lo lho conoilion
1(0)c
I
1(0)c
0
.
whoio wo hayo usoo lho facl lhal inyoslois who oo nol liaoo loso lhoii posloo collaloial.
1his conoilion is cloaily always salisloo.
1ho CCI again choosos lo maximizo lolal oxpocloo wolfaio al t = 1 which is piopoilional
lo c
I
c

= (c
I
c
0
) (c
0
c

). 1his allows us lo oxpioss lho pioLlom foi lho CCI in

loims of c. lho numLoi of spoculalois solling lho socuiily ano c

. lho posilion limil on salos

of lho socuiily. 1ho CCI lhon solyos lho following pioLlom
max
c[0.1[.o

0
\ (c. c

) =
2
1 (1 2c):
(c
0
c

)
suLjocl lo: (28) if :
0
: ano c 0. (24) if :
0
< :.
(28) comLinoo wilh (2). (28) ano (20) giyos us
:
0
c
0
c

2c: (1 c:) (1 (1 2c):)

1 (1 2c):
1 (1 2c):
. (80)
17
Whilo (24) comLinoo wilh (2). (28) ano (20) giyos us
:
0
(c
0
c

)
1 (1 2c) :

1 (1 2c)
2
:
2

1 (1 2c):
1 (1 2c):
. (81)
IroposItIon 8. 5& :
0
: nnJ h |nnn: ]n J]n&| n:n.n. ..) 1: :
0

[:. c
0
) . . .nn| c (0. 1) nnJ c

= 0 hn h: . n .. :hnh.|.j ]
J]n&|. ...) 1: :
0
( :. :) . . .nn| c = 0 nnJ c

= 0. hn h: . n
J]n&|.
1:]. 1ho oLjocliyo funclion of lho plannoi is oocioasing in c

ano incioasing in c. Lul

c

= 0 ano c = 1 is nol foasiLlo as lhis yiolalos lho consliainl. Supposo lisl c = 0. so lhal
lho consliainl is iiioloyanl. 1hon lho plannoi sols c

= 0. ano ils oLjocliyo funclion is

\ (0. 0) =
2c
0
1 :
.
Supposo now c 0. so lhal lho plannoi facos lho iosouico consliainl (80). If (80) ooos nol
Lino. il is always oplimal foi any giyon c (0. 1[ lo oocioaso c

unlil il Linos. Using (80)

lo gol an oxpiossion foi c
0
c

. ano ioplacing il in lho oLjocliyo funclion of lho plannoi.

wo gol lhal lho plannoi sooks lo n.n.n..
(1 (1 2c):)2c: (1 c:) (1 (1 2c):)

1 (1 2c)
2
:
2
.
wilh iospocl lo c. 1his funclion is concayo ano unimooal in c foi all yaluos of :. Sinco il is
incioasing al c = 0. wo lisl nooo lo compaio lho yaluo of lhis funclion al c = 0 ano c = 1.
Al c = 0. il is (1 :)

1 :
2
whilo al c = 1. il is (1 :)2: (1 :
2
)

1 :
2
. cloaily
gioaloi lhan (1 :)

1 :
2
. Honco. lho plannoi woulo piofoi lo sol c as low as possiLlo.
1ho iosliiclion lhal c

0. howoyoi imposos lhal

2c: (1 c:) (1 (1 2c):)

1 (1 2c):
1 (1 2c):

:
0
c
0
. (82)
Sinco lho lofl hano sioo is sliiclly incioasing in c. lho plannoi will sol c so lhal (82) Linos
ano c

= 0. Wilh c

= 0. lho plannoi`s payol is

\ (c. 0) =
2
1 (1 2c):
c
0
\ (0. 0) .
Al c = 0. wo hayo lhal
(1 :)

1 :
1 :

:
0
c
0
. (88)
which may nol Lo salisloo. if :
0
is loo closo lo c
0
. Dolno : as
: = c
0
(1 :)

1 :
1 :
18
1hon. foi all :
0
:. (88) is yiolaloo. ano c is oplimally sol such lhal (82) Linos. 1hon.
c 0 ano c

= 0. foi all :
0
< : wo hayo lhal (88) is salisloo. ano lho plannoi oplimally
sols c = 0. As lhoio is lhon no oofaull. lho plannoi also sols c

= 0.
Nolico lhal lho sol ( :. :) can Lo omply if : < :. Howoyoi lo Lo conciso. wo oio nol mako
lho oislinclion. Whon lho plannoi facos oofaull. lhoio nooos lo Lo sumcionl funos ayailaLlo
lo coyoi oofaull lossos. Lossos can Lo miligaloo whon c

0. 1his is howoyoi coslly as lhis

moans funoamonlal sollois hayo lo koop somo of lhoii socuiilios. Giyon c

= 0. lho plannoi
piofois lo limil lossos Ly iooucing lho numLoi of sollois. As lho oofaull pioLlom Locomos
moio aculo. c oyonlually ioachos zoio. so lhal all spoculalois aio Luyois ano lhoiofoio oo
nol oofaull. Giyon funoamonlal Luyois incui a iolaliyoly laigo cosl of holoing socuiilios.
lhoio is a (posiLly omply) iogion whoio lhoy oo nol oofaull. Onco funoamonlal sollois hayo
an inconliyo lo oofaull. lho plannoi sols c

0 lo limil oofaull lossos. as wo now show.

Lenna 9. 5& :
0
< : nnJ h |nnn: ]n J]n&| n:n.n. Jhn . . .nn|
c = 0 nnJ c

0.
1:]. 1ho pioof is in lhioo slops. Fiisl. wo show lhal c = c

= 0 is nol foasiLlo. Socono.

wo show lhal al c

= 0. c 0 is nol foasiLlo. 1hoiofoio. wo concluoo lhal c 0 ano c

0.
Finally. wo show lhal lhoio oxisl c

0 foasiLlo such lhal c = 0.

5 1. Wo lisl show lhal if :
0
< :.. lhon c = c

= 0 is nol foasiLlo. Al c = 0. lho

Luogol consliainl (81) is
:
0
(c
0
c

)
1 :

1 :
2

1 :
1 :
.
:
0
< : =
(2 c) (1 :)
2
c
0
.
: = c
0
(1 :)

1 :
1 :
1hoio is a c such lhal : :. If c = 1. lhis ooponos on :. Wilh c = 1 (lhis is lho Losl
caso sconaiio in loims of no-oofaull):
:
0
< : =
(1 :)
2
c
0
.
Honco. if c

= 0. lho consliainl is
:
0
c
0
(1 :) c
0

1 :
2

1 :
1 :
10
which can`l Lo lho caso sinco :
0
< (1 :) c
0
2. Honco. wo can`l hayo Lolh c = 0 ano
c

= 0.
5 .. Wo now show lhal al c

= 0. c 0 is nol foasiLlo. Inoooo. lho iighl hano sioo of

(81) is sliiclly incioasing in c. ano wo showoo in Slop 1 lhal c = c

= 0. is nol foasiLlo.
Honco. al c

= 0. incioasing c will nol Lo foasiLlo. So. oilhoi c 0 ano c

0. oi lhoio is
no liaoo.
5 . 1ho plannoi sooks lo maximizo \ (c. c

) =
2
1(12c)a
(c
0
c

) suLjocl lo (81). As
Lofoio. (81) will Lino ano ioplacing lho oxpiossion foi (c
0
c

) in lho plannoi`s oLjocliyo

funclion. wo gol lhal lho plannoi sooks lo n.n.n..
1 (1 2c)
2
:
2

1 (1 2c)
2
:
2
2

1 (1 2c)
2
:
2
.
1his is a sliiclly incioasing funclion of c ano lhoiofoio lho plannoi oplimally sols c = 0
ano
c

= c
0

:
0

1 :
(1a

)
2

1a
1a

Giyon :
0
< : = (1 :) c
0
2. wo oLlain
c

c
0

(1 :) c
0

2 (1 :) (1 :
2
)

1a
1a
0.
so lhal lhis c

is foasiLlo.
Il is insliucliyo lo soo lhal as soon as a oofaull pioLlom appoais lhoio is a oisciolo jump
oownwaios in c ano lho posiliyo mulualizoo oofaull funo is inliooucoo. 1his is inluiliyo. As
spoculalois aio slill solling lhoy hayo an inconliyo lo oofaull foi somo 0. 1o coyoi foi lossos.
loss cash is liansfoiioo lo funoamonlal Luyois foi solllomonl. ano lhoy can Luy iolaliyoly
loss socuiilios. 1hoiofoio. lo componsalo foi lho lowoi oomano. moio spoculalois musl Luy
socuiilios (c musl Lo loss lhan ono). As lossos aio sliiclly posiliyo. lhoio is a oisciolo jump
oownwaio in c as woll as in wolfaio. Al somo slago. lho oplimal allocalion implios lhal
spoculalois all Luy lho socuiily. Honco. lhoy oo nol hayo an inconliyo lo oofaull anymoio
ano CCI`s guaianloos aio nol any longoi nooooo. Lyonlually. funoamonlal sollois. howoyoi.
hayo an inconliyo lo oofaull ano guaianloos in foim of a mulualizoo oofaull funo may Lo
nooooo again. Howoyoi. foi lhis caso. posilion limils aio nooooo. loo.
20
Figuio 8: Oplimal (c. c

) (wilh oofaull whon :

0
< c
0
) as a funclion of ayailaLlo collaloial
:
0
.
Figuio 4: Wolfaio wilh oofaull whon :
0
< c
0
= 1.
21
4.4 OptInaI AIIocatIons
Wo now moigo oui chaiacloiizalion of lho oplimal allocalions wilh ano wilhoul oofaull lo
lno lho oplimal allocalions iiiospocliyo of wholhoi oofaull is allowoo oi nol.
IroposItIon 10. Jh: r. : < c
0
. &h hn h .nn| n||n.n . h n-J]n&|
n||n.n ]: n|| ]: :
0
:. 1] : :. h .nn| n||n.n . h J]n&| n||n.n ]:
n|| :
0
:. 1] : < :. h .nn| n||n.n . h J]n&| n||n.n ]: n|| :
0
( :. :).
nnJ h n-J]n&| n||n.n ]: n|| :
0
:.
1:]. Lol us lisl consiooi lho caso whoio :
0
[:. c
0
). 1hon. wolfaio wilh oofaull is
(piopoilional lo)
c
I
c

=
2
1 (1 2c) :
c
0
.
whoio c is oolnoo Ly (82) holoing wilh ooualily. Sinco (82) ooos nol holo wilh ooualily
whon c = 12. wo know lhal lho oplimal yaluo foi c is sliiclly loss lhan 12. Honco. wolfaio
wilh oofaull is sliiclly lowoi lhan 2c
0
. Howoyoi. wolfaio wilh no oofaull is piopoilional lo
2:
0
. Honco. whon :
0
is closo lo c
0
. lho oplimal allocalion is lho no-oofaull allocalion.
Now. lol us consiooi lho caso whon :
0
( :. :). whoio : = c
0
(1 :)

1a
1a
. 1hon wolfaio
wilh oofaull is (piopoilional lo)
c
I
c

=
2
1 :
c
0
.
Al :
0
= :. wolfaio wilh no oofaull is
c
I
c

= 2:
0
= 2c
0
(1 :)

1 :
1 :
which is sliiclly lowoi lhan lho ono wilh oofaull. Wolfaio wilh oofaull is conlinuous ano
sliiclly incioasing in :
0
fiom :. Honco. Ly conlinuily. lhoio oxisls :. such lhal foi all
:
0
(:. :). oofaull is piofoiioo lo no oofaull. Wo also sliongly suspocl lhal : is uniouo.
Finally. consiooi lho caso whoio :
0
< : = (1 :)c
0
2. 1hon allowing foi oofaull. il is
oplimal lo sol c = 0 ano c

0 ano wolfaio is (piopoilional lo)

c
I
c

=
:
0
(1 :
2
)

1
1
2

1 :
2
.
Whilo wolfaio is piopoilional lo 2:
0
in lho caso wilh no oofaull. 1hoifoio. lhoio is a uniouo
:. such lhal foi all : :. oofaull is piofoiioo lo no oofaull. ano inyoisoly foi : < :. 1ho
iosl of lho Iioposilion follows oiioclly fiom oui pioyious iosulls.
1ho lwo following lguios illuslialo lho oiloionl casos.
22
Figuio : Wolfaio wilh ano wilh no oofaull. : = 0.1. c
0
= 1.
Figuio 6: Wolfaio wilh ano wilh no oofaull. : = 0.7 ano c
0
= 1.
28
5 InpIenentatIon
Wo inyosligalo now. how aclual iisk managomonl omployoo in piaclico Ly CCIs achioyo
lho oplimal allocalion wo hayo oosciiLoo in Soclion 4. Iisk managomonl inyolyos lho
choico of guaianloos againsl oofaull oxposuio ano collaloial policios maigin calls. oofaull
funo ano liaoing limils. Wo will show lhal commonly omployoo iisk managomonl lools can
achioyo lho oplimal allocalion Ly inluoncing inyoslois` liaoing Lohayioi in oouiliLiium. 1ho
comLinalion of of iisk managomonl lools omployoo will oopono on lho amounl of liouioily
ano collaloial (:
0
) iolaliyo lo oyoiall liaoing nooos (c
0
) ano lho oyoiall polonlial oofaull
iisk giyon Ly 0
nnx
. Oui oxposilion hoio again assumos lhal 0
nnx
= 2.
Wo now oolno whal wo moan Ly implomonlalion. A collaloial policy is summaiizoo Ly
a yocloi n = (n
I
. n

. n
c
). whoio n
I
is lho cash in hano of lypo / liaoois al lho limo of
solllomonl. A collaloial policy is foasiLlo if n
0
. lho woighloo sum of n
I
. is loss lhan :
0
.
An allocalion (c
I
. c

) is lhon implomonlaLlo if lhoio is a foasiLlo collaloial policy such lhal

lho iosulling maikol oouiliLiium allocalion is (c
I
. c

). In lho soouol. wo will show how lo

iolalo lho collaloial policy n lo maigin call. oofaull funos ano posilion limils.
5.1 ovatIon and AargIn HequIrenents
As oui noimaliyo analysis showoo. in gonoial lho CCI has lo ioouiio collaloial lo iulo oul
oofaull. 1ho ioason is lhal oxchanging collaloial ox-anlo Lolwoon liaoing pailios ooos nol
alloyialo lho oofaull pioLlom. Honco. il is ciucial lhal lho collaloial facilily opoialos as
an inooponoonl lhiio-paily lhal noyalo liaoos. 1ho collaloial facilily lhon inloiposos ilsolf
Lolwoon lho liaoing pailios ano Locomos lho Luyoi of oyoiy solloi ano lho solloi of oyoiy
Luyoi. Il is also impoilanl lhal lho conliacl Lo logally Linoing. i..o lhal lho iosouicos of
lho collaloial facilily Ly sumcionl lo coyoi any oofaull loss.
Collaloial policios oopono on lho amounl of collaloial ayailaLlo. Whon lho assol oligiLlo as
collaloial (hoio cash) is sumcionlly plonliful iolaliyo lo liaoing nooos ano lho oxposuio lo
oofaull. i.o. :
0
(1 :) c
0
(1 :). collaloial policios (oofaull funos oi maigin calls) aio
inooloiminalo. In lhis caso. lho omcionl allocalion is implomonlaLlo n .] collaloial is nol
ayailaLlo foi sollling lho liaoo. Whon cash is scaico. Lul sumcionl lo fully collaloializo all
liaoos. lwo issuos omoigo. Fiisl. inyoslois musl Lo aLlo lo uso somo of lho cash posloo as
collaloial foi sollling lhoii liaoo. Socono. lho oisliiLulion of solllomonl Lalancos inluoncos
lho piico al which lho socuiily is liaooo in oouiliLiium.
24
Whon :
0
[c
0
. (1 :) c
0
(1 :)). lho oplimal allocalion is giyon Ly c
I
= c
0
:
0
= :

.
As lhoio is no oofaull ano spoculalois musl Lo inoiloionl Lolwoon Luying ano solling. wo
nooo lhal
n
I
c
I
c
0
= j =
:

c
0
. (84)
Honco. foi n
I
= n

= :
0
. wo hayo lhal j = 1 in oouiliLiium. 1ho CCI lhon achioyos
lho oplimal allocalion Ly ioouiiing collaloial al lho liaoing slago t = 1 ooual lo :
0
. which
is usoo lo oiioclly solllo lho liaoo al t = 2. Ioouiiing collaloial in lho foim of nn:n.n
n|| i.o. conoilionally on laking a pailiculai liaoing posilion implomonls lho oplimal
allocalion. Using maigin calls. inyoslois can noyoi liaoo moio lhan lhoii solllomonl Lalancos
as olhoiwiso lhoy woulo yiolalo lho maigin ioouiiomonl. In lhis sonso. solllomonl Lalancos
ano maigin calls aio in facl ioonlical ano all liaoos aio sollloo fully againsl lho maigin.
IroposItIon 11. 5&
1a
1a
c
0
:
0
c
0
. ||n:n| ]n.|.j nn.nn :nJ nn
nh. h .n:n.nJ) .n n||n.n. hj :n&.:.nn n nn:n.n n|| n&n| :
0
nnJ
n||&.nn J nn:n.n h &J ]: |.nn :nJ.
Nolo lhal as liouioily falls. lho ialio Lolwoon collaloial ano liaoo sizo slays lho samo.
1ho only foaluio lhal changos in oouiliLiium is lho posilion lhal spoculalois lako. As :
0
ooclinos. moio ano moio spoculalois Locomo Luyois unlil lho numLoi of sollois ano Luyois
aio lho samo al :
0
= c
0
. Maigin calls ooual lo :
0
oo nol inluonco lho piico which is
conslanl al t = 1 ano. honco. inooponoonl of lho amounl of collaloial iolaliyo lo lho sizo of
lho maikol as giyon Ly c
0
.
5.2 Cuarantees, AutuaIIzed DeIauIt Fund and IosItIon LInIts
In piinciplo. lho CCI woulo liko lo iulo oul oofaull ano hayo lho highosl liaoing yolumo
possiLlo. If collaloial is sumcionlly scaico (:
0
< c
0
). lhoso lwo oLjocliyos aio incompaliLlo.
1ho CCI has lhon lo guaianloo againsl oofaull ano Lack lhis guaianloo up Ly using a
oofaull funo.
1ho CCI can guaianloo no oofaull foi Luyois Ly solling a oofaull funo al t = 0 ooual lo
1 = :
0
n
0
. whoio n
0
is lho lolal amounl of solllomonl Lalancos ayailaLlo lo inyoslois.
1his oofaull funo is mulualizoo lo coyoi all oofaull oxposuio. Fuilhoimoio. maigin calls sol
ooual lo n
0
allow foi maximum liaoo ano achioyo lho oplimal allocalion as long as :
0
:.
If :
0
< :. lho CCI usos also posilion limils. Il iosliicls lho amounl of socuiilios lhan can
Lo solo. Lul allows foi as many socuiilios lo Lo Loughl as possiLlo.
2
Whal is impoilanl foi implomonling lho oplimal allocalion. is lho lolal amounl of collaloial
oaimaikoo foi guaianling solllomonl ano foi oiiocl solllomonl. 1ho CCI foi oxamplo
coulo also ioly only on lho oofaull funo. Lul oaimaik a sumcionl shaio (:
0
n
0
):
0
as a
guaianloo. 1ho iosl of lho funo coulo Lo usoo foi solllomonl. Again. ioluining lho oofaull
funo only foi solllomonl. implomonls lho oplimal allocalion uniouoly foi a pioll-oiionloo
CCI. Honco. il is nol lho oislinclion Lolwoon maigin calls ano oofaull funo poi so whal
mallois. Lul wholhoi lhoso funos mulually guaianloo solllomonl oi nol.
IroposItIon 12. 1 :
0
(0. c
0
). 1 nh. h .nn| n||n.n hj &.nn n
J]n&| ]&nJ n&&n||j n&n:nn |nn ] :nJ. h& n||& n|| h: ||n:n| h
&J ]: |nn. 1&:h:n:. .] :
0
< :. h 1 .n ..n |.n. n ||.nn
h &:.j.
Il is insliucliyo lo look al lho piicos al which liaoing lakos placo foi :
0
< c
0
. Iiicos aio
always Lolow 1. if wo assumo ooual solllomonl Lalancos oi. oouiyalonlly. maigin calls
ano lako inlo accounl lhal wo mighl nooo a mulualizoo oofaull funo. Iiicos aio lhon giyon
Ly
n
0
c
I
c
0
= j. (8)
1his implios foi :
0
(:. c
0
).
n
0
c
I
c
0
=
1
1 c:
1 (1 2c):
1 (1 2c):

:
0
c
0
2c:

= j. (86)
Using lho oolnilion of c. wo oLlain
j =

1 (1 2c)
2
:
2
< 1. (87)
Honco. sollois hayo slill a piofoionco lo soll lho socuiily. as lhoy hayo an oplion yaluo of
oofaull. In facl. lho piico jusl Lalancos lho inconliyos lo Luy lho socuiily. as il makos lho
socuiily choap lo puichaso. 1ho piico ooclinos wilh :
0
. as c lho numLoi of spoculalois
lhal soll also oocioasos.
If :
0
falls inlo lho iogion ( :. :). wo oo nol hayo lo oofaull ano :
0
= n
0
. Wilh maigin
calls. lho piico is lhon giyon Ly
:
0
c
I
c
0
=
:
0
c
0
1 :
1 :
= j. (88)
Using lho oolnilion of : = (1 :)

1a
1a
c
0
. wo oLlain
j < (1 :)

1 :
1 :
< 1. (80)
26
Honco. spoculalois hayo a sliicl piofoionco lo Luy lho socuiily (c = 0) as lho piico is Lolow
lhoii oxpocloo yalulion of lho socuiily ano lhoio is no oofaull. Also nolo lhal lho piico
ooclinos wilh :
0
.
Finally. foi : < :. wo hayo lhal
n
0
c
I
c
0
=
1 :
1 :
:
0
c
0
c

=
1 :
1 :
:
0
n
0

(1 :)
1 :
2
2

1 :
1 :

= j. (40)
Using lho oolnilion of n
0
. wo gol
j = (1 :)
2

1 :
2
< 1. (41)
Hoio again. piicos aio loss lhan ono ano all spoculalois aio sollois. Sollois oLlain a low
piico. so foi 0 high onough. lhoy hayo an inconliyo lo oofaull ano a oofaull funo lo lnanco
a guaianloo is nooooo. Inloioslingly. lho piico slays conslanl foi lhis iogion. as posilion
limil succossiyoly iosliicl liaoing as :
0
ooclinos. In conclusion. lho cloaiing aiiangmonls
lhiough a conlial counloipaily lowois liaoing piicos ano oospilo incuiiing a oofaull iisk
impioyos lho allocalion lho maikol achioyos. Wilhoul such an aiiangomonl. ayoioing
oofaull woulo hayo ioouiioo posilion limils ano liaoo al j = 1.
6 ConcIusIon
Wo pioyioo a simplo moool of a Conlial Counloipaily. 1ho fiiclions wo consiooi (liaoos aio
limo-ciilical. limiloo liouioily ano limiloo commilmonl) aio common in slock oxchangos.
ano wo show lhal lhoy aio sumcionl fiiclions lo oxplain why CCIs noyalo liaoo. 1ho moool
is also aLlo lo oxplain cuiionl collaloial piaclicos of opoialing CCIs.
1hoio aio many issuos lhal iomain lo Lo sluoioo. Fiisl. lho willingnoss of lho CCI lo
lako on iisk mighl oopono on ils goyoinanco sliucluio. Cuiionlly CCIs opoialo unooi lwo
main goyoinanco sliucluios. 1ho lisl sliucluio is lho mulual ownoiship of lho CCI among
momLois. Wo will iofoi lo such inslilulions as usoi-oiionloo CCIs. 1ho socono lypo of
inslilulions is opoialoo on a foi-pioll Lasis. ialhoi lhan oplimizing lho pioyision of soiyicos
foi lho majoiily of ils usois. 1iaoilionally CCIs woio usoi-oiionloo inslilulions. Lul laloly
many CCIs hayo oomulualizoo ano swilchoo lhoii oLjocliyos lowaio pioll-maximizalion.
Lxplaining lho ioasons ano lho implicalions of lhis shifl is oLyioulsy an impoilanl ouoslion.
Also. wo hayo lofl asioo issuos of compolilion ano lho consoouoncos of CCIs failuio in caso
of a syslomic oyonl. 1hoso aio also ciucial ouoslions ano wo hopo lhal lhis papoi pioyioos
a usoful lisl Lonchmaik lo sluoy lhoso ano olhoi issuos on CCIs.
27
CFS Working Paper Series:
No. Author(s) Title
2008/41 Terrence Hendershott
Charles M. Jones
Albert J. Menkveld
Does Algorithmic Trading Improve Liquidity?
2008/40 Jonathan Field
Jeremy Large
Pro-Rata Matching and One-Tick Futures Markets
2008/39 Giovanni Cespa
Thierry Foucault
Insiders-Outsiders, Transparency and the Value of
the Ticker
2008/38 Rachel J. Huang
Alexander Muermann
Larry Y. Tzeng
Hidden Regret in Insurance Markets: Adverse and
Advantageous Selection
2008/37 Alexander Muermann
Stephen H. Shore
Monopoly Power Limits Hedging
2008/36 Roman Inderst Retail Finance: Bringing in the Supply Side
2008/35 Dimitris Christelis
Tullio Jappelli
Mario Padula
Cognitive Abilities and Portfolio Choice
2008/34 Tullio Jappelli
Marco Pagano
Information Sharing and Credit: Firm-Level
Evidence from Transition Countries
2008/33 Tullio Jappelli
Marco Pagano
Financial Market Integration under EMU
2008/32 Fancis X. Diebold
Georg H. Strasser
On the Correlation Structure of Microstructure
Noise in Theory and Practice
Copies of working papers can be downloaded at http://www.ifk-cfs.de