What do central counterparty default funds really cover? A network-based stress test answer

In recent years, an increased effort has been made to further the development of effective stress tests that can be used to quantify the resilience of financial institutions. Here, we propose a stress test methodology for central counterparties (CCPs) based on a network characterization of clearing members (CMs) that takes into account the propagation and amplification of financial distress through the network of bilateral exposures between CMs. We apply the proposed framework to the fixed-income asset class of Cassa di Compensazione e Garanzia (CC&G), the CCP operating in Italy, whose cleared securities are mainly Italian government bonds. We consider two different scenarios where exogenous losses may be incurred: a distributed initial shock and a shock corresponding with the cover 2 regulatory requirement (entailing the simultaneous default of the two most exposed CMs). Network effects turn out to substantially increase the vulnerability of the CMs in both scenarios, though distress propagation is much more rapid in the latter case, where we note a large number of early triggered additional defaults. This shows that setting a default fund to cover insolvencies on a cover 2 basis alone may not be adequate for the taming of systemic events. Overall, our network-based stress test methodology represents a refined tool for calibrating conservative default fund amounts.