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We introduce a dynamic model of the default waterfall of derivatives central counterparties and propose a risk sensitive method for sizing the initial margin, and the default fund and its allocation among clearing members. Using a Markovian structure model of joint credit migrations, our evaluation of the default fund takes into account the joint credit quality of clearing members as they evolve over time. Another important aspect of the proposed methodology is the use of the time consistent dynamic risk measures for computation of the initial margin and the default fund. We carry out a comprehensive numerical study, where, in particular, we analyze the advantages of the proposed methodology and its comparison with the currently prevailing methods used in industry.
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