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The Limits of Central Counterparty Clearing: Collusive Moral Hazard and Market Liquidity

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Author Info

  • Thorsten V. Koeppl

    ()
    (Queen's University)

Abstract

Can central counterparty (CCP) clearing control counterparty risk in the presence of risk taking that can aggravate such risk? When counterparty risk is not observable, I show that central clearing leads to higher collateral requirements for two different reasons. Without collusion about risk taking, a CCP offering diversification of risk cannot selectively forgo incentives for transactions that use collateral only for insurance. With collusion about risk taking, a CCP needs to charge collateral in line with the worst counterparty quality to control risk taking. Requiring more collateral reduces market liquidity and worsens incentives causing a feedback effect that amplifies collateral costs.

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File URL: http://qed.econ.queensu.ca/working_papers/papers/qed_wp_1312.pdf
File Function: First version 2013
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Bibliographic Info

Paper provided by Queen's University, Department of Economics in its series Working Papers with number 1312.

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Length: 34 pages
Date of creation: Jun 2013
Date of revision:
Handle: RePEc:qed:wpaper:1312

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Keywords: CCP Clearing; Counterparty Risk; Moral Hazard; Collateral; Market Liquidity;

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References

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  1. Bruno Biais & Florian Heider & Marie Hoerova, 2012. "Clearing, Counterparty Risk, and Aggregate Risk," IMF Economic Review, Palgrave Macmillan, vol. 60(2), pages 193-222, July.
  2. Wagner, W.B., 2006. "Diversification at Financial Institutions and Systemic Crises," Discussion Paper 2006-71, Tilburg University, Center for Economic Research.
  3. Thorsten Koeppl & Cyril Monnet, 2006. "Central Counterparties," 2006 Meeting Papers 513, Society for Economic Dynamics.
  4. Thorsten Koeppl & Cyril Monnet & Ted Temzelides, 2009. "Optimal Clearing Arrangements for Financial Trades," Working Papers 1222, Queen's University, Department of Economics.
  5. Markus K. Brunnermeier & Lasse Heje Pedersen, 2007. "Market Liquidity and Funding Liquidity," NBER Working Papers 12939, National Bureau of Economic Research, Inc.
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Cited by:
  1. Radoslav Raykov, 2014. "Optimal Margining and Margin Relief in Centrally Cleared Derivatives Markets," Working Papers 14-29, Bank of Canada.

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