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Clearing, Counterparty Risk, and Aggregate Risk

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  • Bruno Biais
  • Florian Heider
  • Marie Hoerova

Abstract

The paper studies the optimal design of clearing systems. The paper analyzes how counterparty risk should be allocated, whether traders should be fully insured against that risk, and how moral hazard affects the optimal allocation of risk. The main advantage of centralized clearing, as opposed to no or decentralized clearing, is the mutualization of risk. While mutualization fully insures idiosyncratic risk, it cannot provide insurance against aggregate risk. When the latter is significant, it is efficient that protection buyers exert effort to find robust counterparties, whose low default risk makes it possible for the clearing system to withstand aggregate shocks. When this effort is unobservable, incentive compatibility requires that protection buyers retain some exposure to counterparty risk even with centralized clearing.

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Bibliographic Info

Article provided by Palgrave Macmillan in its journal IMF Economic Review.

Volume (Year): 60 (2012)
Issue (Month): 2 (July)
Pages: 193-222

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Handle: RePEc:pal:imfecr:v:60:y:2012:i:2:p:193-222

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  1. Thorsten Koeppl & Cyril Monnet, 2006. "Central Counterparties," 2006 Meeting Papers 513, Society for Economic Dynamics.
  2. Stephens, Eric & Thompson, James, 2011. "CDS as Insurance: Leaky Lifeboats in Stormy Seas," Working Papers 2011-9, University of Alberta, Department of Economics.
  3. James R. Thompson, 2010. "Counterparty Risk in Financial Contracts: Should the Insured Worry about the Insurer?," The Quarterly Journal of Economics, MIT Press, vol. 125(3), pages 1195-1252, August.
  4. Thorsten Koeppl & Cyril Monnet & Ted Temzelides, 2009. "Optimal Clearing Arrangements for Financial Trades," Working Papers 1222, Queen's University, Department of Economics.
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