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Transparency and Collateral: The Design of CCPs' Loss Allocation Rules

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Abstract

This paper adopts a mechanism design approach to study optimal clearing arrangements for bilateral financial contracts in which an assessment of counterparty risk is crucial for efficiency. The economy is populated by two types of agents: a borrower and lender. The borrower is subject to limited commitment and holds private information about the severity of such lack of commitment. The lender can acquire information at a cost about the commitment of the borrower, which affects the assessment of counterparty risk. When truthful revelation by the borrower is not incentive compatible, the mechanism designer optimally trades off the value of information about the lack of commitment of the borrower with the cost of incentivizing the lender to acquire such information. Central clearing of these financial contracts through a central counterparty (CCP) allows lenders to mutualize their counterparty risks, but this insurance may weaken incentives to acquire and reveal informatio n about such risks. If information acquisition is incentive compatible, then lenders choose central clearing. If it is not, they may prefer bilateral clearing to prevent strategic default by borrowers and to economize on costly collateral. Central clearing is analyzed under different institutional features observed in financial markets, which place different restrictions on the contract space in the mechanism design problem. The interaction between the costly information acquisition and the limited commitment friction differs significantly in each clearing arrangement and in each set of restrictions. This results in novel lessons about the desirability of central versus bilateral clearing depending on traders' characteristics and the institutional features defining the operation of the CCP.

Suggested Citation

  • Gaetano Antinolfi & Francesca Carapella & Francesco Carli, 2019. "Transparency and Collateral: The Design of CCPs' Loss Allocation Rules," Finance and Economics Discussion Series 2019-058, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2019-58
    DOI: 10.17016/FEDS.2019.058
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    References listed on IDEAS

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    Cited by:

    1. Bardoscia, Marco & Caccioli, Fabio & Gao, Haotian, 2022. "Efficiency of central clearing under liquidity stress," Bank of England working papers 1002, Bank of England.

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    More about this item

    Keywords

    Limited commitment; Central counterparties; Collateral;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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