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Settlement Gap Risk

Exchanging collateral has emerged as the market standard for mitigating counterparty credit risk in the interbank derivatives market. Collateral postings do not, however, eliminate that risk completely. Most notably, the so-called gap risk remains, which is the risk that in the event of counterparty default, mismatches between the collateral account and the portfolio market value build up between the last margin call and the end of the close-out process. Such gaps are most pronounced when the portfolio market value changes heavily during the margin period of risk. Since portfolio value changes are driven by market movements on the one hand and by incoming or outgoing contractual cashflows on the other hand, gap risk decomposes into a component driven by market movements and a component driven by settlement payments. In this article, we separate these components from one another. We thereby introduce two new risks which we think should be measured and managed separately. The settlement induced component of gap risk, which we call Settlement Gap Risk (SGR), can be the dominant source of gap risk on individual time buckets, and it will not be fully covered by bilateral exchange of initial margin. We present a framework for measuring, managing and mitigating these two new risks, building upon a Monte Carlo based exposure simulation.