When a clearing member defaults, the CCP runs a loss waterfall: the defaulter's initial margin first, then the defaulter's contribution to the default fund, then the CCP's own "skin in the game," then surviving members' default fund contributions, then assessment rights against members. The 2008 collapse of Lehman tested this waterfall in real time: it held, but barely. Understanding the waterfall is the line between knowing what a CCP is and knowing whether one is actually safe.
A CCP sits between counterparties on a cleared trade. After execution, the trade is novated: original Party A and Party B each become trades with the CCP. Party A trades with CCP-as-Party-B; Party B trades with CCP-as-Party-A. The CCP nets all positions across all members and runs collateral, default management, and risk infrastructure.
Novation legally extinguishes the original bilateral contract and replaces it with two new contracts. From a credit perspective, members no longer have exposure to each other; they have exposure only to the CCP.
Common mistakes
- Putting surviving members ahead of CCP skin-in-the-game in the waterfall. The defaulter's IM and DFC come first, then CCP capital, then surviving members' DFC. A choice that flips the order is wrong.
- Treating CVA as a default-only risk. CVA is mark-to-market: it changes with credit spreads even when no default occurs. Stressed CVA captures spread-widening losses without defaults. Trap: a choice that says "CVA captures only realized default losses" misses the mark-to-market dimension.
- Using historical PDs for CVA. CVA is a market price; it requires risk-neutral PDs from CDS or credit spreads. Historical PDs are 2, 5x smaller and would understate CVA. Trap: a question gives both historical and CDS-implied PDs and asks for CVA. The answer uses risk-neutral.
Bottom line
- Central counterparty (CCP) novates trades, replacing the original counterparty. Multilateral netting and a default waterfall replace bilateral exposure with mutualized risk.
- Loss waterfall: defaulter's IM, defaulter's default fund, CCP capital, surviving members' default fund, assessment rights, VMGH, then resolution. Each layer absorbs in order.
- xVA components: CVA (counterparty credit), DVA (own credit), FVA (funding), KVA (capital), MVA (initial margin); total xVA can add 20-30 bps to uncollateralized derivative pricing.
- CVA = expected counterparty default loss, the integral of EE × PD × LGD over the horizon using risk-neutral PDs; spreads moving without defaults generate "CVA risk" P&L.
Exam shortcut
When a question asks about CCP loss absorption order, write the waterfall from memory: defaulter IM → defaulter DFC → CCP capital → surviving DFC → assessment → VMGH. When it asks for CVA on an uncollateralized trade, multiply (1 − R) × average EE × hazard-rate integral. When it asks for prepayment-driven cash flows, use SMM = 1 − (1 − CPR)^(1/12) to convert annual CPR to monthly.
The full lesson (about 3,517 words, 23 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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