The CCP Recovery Game: The Default Auction as a Stag Hunt

In this article, we use game theory to study crisis dynamics at derivatives clearinghouses (CCPs). The mandate to clear standardized derivatives through CCPs has been a pillar of post-crisis reforms. Since the resilience of CCPs is now crucial to financial stability, regulators, academics and practitioners are at work designing an adequate framework for CCP recovery and resolution. So far, however, few have studied the behavior of a CCP’s clearing members during crisis. Doing so requires both a formal economic model and an understanding of the legal and institutional features of CCP default auctions – the latter traditionally the domain of practitioners. Our paper is the first to unite these fields, providing a model that is rigorous and institutionally grounded. We analyze clearing members’ behavior at the auction that follows a clearing member default. We find that the auction works as a “stag hunt” game with two equilibria: a cooperative equilibrium, where clearing members bid boldly and avert crisis, and an uncooperative equilibrium where they bid timidly and the auction fails. The potential for a CCP to reach the uncooperative equilibrium suggests that a key goal of recovery planning should be to tilt clearing members’ incentives towards the socially optimal cooperative equilibrium.