Liquidity and Central Clearing: Evidence from the CDS Market

An international initiative to increase the use of central clearing for OTC derivatives emerged as one of the reactions to the 2008 financial crisis. The move to central clearing is a fundamental change in the structure of the market. Central clearing will help control counterparty credit risk, but it also has potential implications for market liquidity. We analyze the relationship between liquidity and central clearing using information on credit default swap clearing at ICE Trust and ICE Clear Europe. We find that the central counterparty chooses the most liquid contracts for central clearing, consistent with liquidity characteristics being important in determining the safety and efficiency of clearing. We further find that the introduction of central clearing is associated with a slight increase in the liquidity of a contract. This is consistent with two countervailing effects. On one hand, central clearing will likely increase collateral requirements relative to the pre-reform bilaterally-cleared market, thereby increasing clearing costs and possibly reducing the liquidity of the market. On the other hand, improved management of counterparty credit risk, increased transparency and operational efficiencies at central counterparties could bring more competition into OTC derivative markets and serve to increase liquidity.