Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/311780 
Year of Publication: 
2024
Series/Report no.: 
Bank of Canada Staff Working Paper No. 2024-46
Publisher: 
Bank of Canada, Ottawa
Abstract: 
Derivatives exchanges often determine collateral requirements, which are fundamental to market safety, with dated risk models assuming normal returns. However, derivatives returns are heavy-tailed, which leads to the systematic under-collection of collateral (margin). This paper uses extreme value theory (EVT) to evaluate the cost of this margin inadequacy to market participants in the event of default. I find that the Canadian futures market was under-margined by about $1.6 billion during the Great Financial Crisis, and that the default of the highest-impact participant generates a cost of up to $302 million to be absorbed by surviving participants. I show that this cost can consume the market's entire default fund and result in costly risk mutualization. I advocate for the adoption of EVT as a benchmarking tool and argue that the regulation of exchanges should be revised for financial products with heavy tails.
Subjects: 
Financial institutions
Financial stability
JEL: 
G10
G11
G20
Persistent Identifier of the first edition: 
Document Type: 
Working Paper

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