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In the last years, increasing efforts have been put into the development ofeffective stress tests to quantify the resilience of financial institutions.Here we propose a stress test methodology for central counterparties based on anetwork characterization of clearing members, whose links correspond to directcredits and debits. This network constitutes the ground for the propagation offinancial distress: equity losses caused by an initial shock with bothexogenous and endogenous components reverberate within the network and areamplified through credit and liquidity contagion channels. At the end of thedynamics, we determine the vulnerability of each clearing member, whichrepresents its potential equity loss. We apply the proposed framework to theFixed Income asset class of CC&G, the central counterparty operating in Italywhose main cleared securities are Italian Government Bonds. We consider twodifferent scenarios: a distributed, plausible initial shock, as well as a shockcorresponding to the cover 2 regulatory requirement (the simultaneous defaultof the two most exposed clearing members). Although the two situations lead tosimilar results after an unlimited reverberation of shocks on the network, thedistress propagation is much more hasty in the latter case, with a large numberof additional defaults triggered at early stages of the dynamics. Our resultsthus show that setting a default fund to cover insolvencies only on a cover 2basis may not be adequate for taming systemic events, and only veryconservative default funds, such as CC&G's one, can face total losses due tothe shock propagation. Overall, our network-based stress test represents arefined tool for calibrating default fund amounts.

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