Clearinghouse Default Waterfalls: Risk-Sharing, Incentives, and Systemic Risk

Abstract

Central to the ongoing debate on default resource adequacy are the incentives provided by the clearinghouse waterfall structure. We show that clearinghouse equity and member default funds play a complementary role to initial margins: they incentivize safe members to participate rather than deterring risky ones from not participating. Our results explain the empirical differences in capitalization and profitability across clearinghouses, and show that temporary low funding cost environments create the illusion that clearinghouses are adequately capitalized. The model sheds normative insights: minimum equity requirements can impose additional costs on members because the clearinghouse's equilibrium response is to increase default funds.