Model risk at central counterparties:is skin in the game a game changer?

As central counterparties (CCPs) have become systemic, their credit risk modeling has become critical for the global financial system. This paper empirically investigates CCPs’ incentives to model credit risk. Our hypothesis is that the more CCPs stand to lose from mismanagement, the more conservatively they model credit risk. Accordingly, we find that the higher the skin in the game, i.e., the CCP capital dedicated to credit risk, the lower the model risk is. The results are significant and robust across different model risk proxies. Consistent with our hypothesis, the association with other forms of capital is not significant. Our findings inform the policy debate on CCP capital regulation.