Data Science Day @ Columbia University

Clearinghouses operate in a highly regulated environment. Collateral requirements are subject to regulatory approval, and are critically reviewed, since collateral is viewed as the first line of protection for the systemi-cally important clearinghouse in the event of a client default. This does not, however, take away entirely the freedom of the clearinghouse to choose her preferred collat-eralization rules. Regulators often require portfolios to be “fully collateralized,” which effectively creates a floor on the level of collateral a clearinghouse can demand. Since collateral, essentially a contingent claim that pays off only when there is a default, protects clearinghouses from counterparty risk, one may argue that it may be incentive compatible for the clearinghouse to impose even higher requirements. Regulatory authorities thus need to understand the incentives of the clearinghouse, so to design policies that align the interests of the clearinghouse with those of the regulator. We design an extensive form game where the profit maximizing clearinghouse clears client trades submitted via a clearing member bank, in the absence of a regulator. We analytically characterize all subgame perfect Nash equilibria, and show that the resulting equilibrium can only involve very low or very high collateral levels, depending on the riskiness of the traded contract and the benefits that clients can capture from trading. When equilibrium collateral levels are high, the introduction of a regulatory constraint would have no effect since the clearinghouse would have chosen high collateral requirements anyway; when equilibrium collateral levels are low, regulations are necessary to protect the clearinghouse from default losses in bad states of nature.