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Centralized netting in financial networks

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  • Garratt, Rodney
  • Zimmerman, Peter

Abstract

We consider how the introduction of centralized netting in financial networks affects total netted exposures between counterparties. In some cases there is a trade-off: centralized netting increases the expectation of net exposures, but reduces the variance. We show that the set of networks for which expected net exposures decreases is a strict subset of those for which the variance decreases, so the trade-off can only be in one direction. For some network structures, introducing centralized netting is never beneficial to dealers unless sufficient weight is placed on reductions in variance. This may explain why, in the absence of regulation, traders in a derivatives network do not develop central clearing. Our results can be used to estimate margin requirements and counterparty risk in financial networks. We also provide techniques to evaluate the robustness of our results to behavioral responses to the introduction of centralized netting.

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  • Garratt, Rodney & Zimmerman, Peter, 2020. "Centralized netting in financial networks," Journal of Banking & Finance, Elsevier, vol. 112(C).
    • Handle: RePEc:eee:jbfina:v:112:y:2020:i:c:s0378426617302959
    DOI: 10.1016/j.jbankfin.2017.12.008
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    2. Berndsen, Ron, 2020. "Five Fundamental Questions on Central Counterparties," Other publications TiSEM 1f3bd844-92ab-4104-8f57-9, Tilburg University, School of Economics and Management.
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    5. H Peyton Young & Mark Paddrik, 2019. "How Safe are Central Counterparties in Credit Default Swap Markets?," Economics Series Working Papers 885, University of Oxford, Department of Economics.
    6. Miyakoshi, Tatsuyoshi & Shimada, Junji, 2022. "Network analysis of local currency Asian government bond markets: Assessments of the ABFI and the ABMI," The North American Journal of Economics and Finance, Elsevier, vol. 62(C).
    7. Benos, Evangelos & Huang, Wenqian & Menkveld, Albert & Vasios, Michalis, 2019. "The cost of clearing fragmentation," Bank of England working papers 800, Bank of England, revised 22 Nov 2019.
    8. Ron Berndsen, 2021. "Fundamental questions on central counterparties: A review of the literature," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 41(12), pages 2009-2022, December.
    9. Tomaž Fleischman & Paolo Dini, 2021. "Mathematical Foundations for Balancing the Payment System in the Trade Credit Market," JRFM, MDPI, vol. 14(9), pages 1-25, September.
    10. Fleischman, Tomaž & Dini, Paolo, 2021. "Mathematical foundations for balancing the payment system in the trade credit market," LSE Research Online Documents on Economics 112151, London School of Economics and Political Science, LSE Library.
    11. EDOARDO GAFFEO & Lucio Gobbi & Massimo Molinari, 2018. "Bilateral netting and systemic liquidity shortages in banking networks," DEM Working Papers 2018/06, Department of Economics and Management.
    12. Injun Hwang & Baeho Kim, 2020. "Heterogeneity and netting efficiency under central clearing: A stochastic network analysis," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 40(2), pages 192-208, February.

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