The Emergence and Future of Central Counterparties
AbstractWe study the role of a central counterparty (CCP) in controlling counterparty risk. When trading is organized via a centralized exchange with fungible contracts -- as in a futures market -- we show that it is optimal to clear trades via a CCP that uses (i) novation to pool the risk of default and (ii) mutualization of losses to insure against the aggregate cost of default in the form of price risk. We then analyze the design of CCP clearing for over-the-counter (OTC) trades where contracts are customized and, hence, not fungible. A CCP can still offer gains from novation by pooling default risk across all customized contracts. Bargaining in OTC trades leads to an inefficient allocation of default risk across trades. A transfer scheme can alleviate this inefficiency, but necessitates novation being offered by a CCP. Hence, the benefit from CCP clearing for OTC markets goes beyond simple netting as it is a prerequisite for an efficient allocation of default risk in such markets.
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Bibliographic InfoPaper provided by Queen's University, Department of Economics in its series Working Papers with number 1241.
Length: 54 pages
Date of creation: Jun 2010
Date of revision:
Central Counterparty; Clearing; Over-the-counter Markets; Novation and Mutualization; Default Risk;
Other versions of this item:
- Thorsten V. Koeppl & Cyril Monnet, 2010. "The emergence and future of central counterparties," Working Papers 10-30, Federal Reserve Bank of Philadelphia.
- G20 - Financial Economics - - Financial Institutions and Services - - - General
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-08-06 (All new papers)
- NEP-BEC-2010-08-06 (Business Economics)
- NEP-CFN-2010-08-06 (Corporate Finance)
- NEP-RMG-2010-08-06 (Risk Management)
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- Gibson, Rajna & Murawski, Carsten, 2013. "Margining in derivatives markets and the stability of the banking sector," Journal of Banking & Finance, Elsevier, vol. 37(4), pages 1119-1132.
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