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Counterparty risk, central counterparty clearing and aggregate risk

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  • Binbin Deng

    (Compass Lexecon)

Abstract

I construct a model of bilateral trading of over-the-counter (OTC) derivatives to study the performance of central counterparty (CCP) clearing. I first show how buyers are exposed to counterparty risk under bilateral clearing. I then show how a CCP can fully insure against counterparty risk through risk-mutualization and achieve full idiosyncratic risk-sharing among market participants. I further demonstrate the impact of aggregate risk on CCP clearing and illustrate a scenario in which the CCP fails to provide full insurance against counterparty risk and full idiosyncratic risk-sharing collapses under severe aggregate risk. To insure against aggregate risk and retain full idiosyncratic risk-sharing, sellers’ capital resource is important on top of CCP mutualization. Finally, I allow buyers to costly search for sellers and study the implications of optimal search effort. I show how a moral hazard problem can arise if effort is unobservable, in which case full CCP insurance against counterparty risk is no longer optimal.

Suggested Citation

  • Binbin Deng, 2017. "Counterparty risk, central counterparty clearing and aggregate risk," Annals of Finance, Springer, vol. 13(4), pages 355-400, November.
    • Handle: RePEc:kap:annfin:v:13:y:2017:i:4:d:10.1007_s10436-017-0308-x
    DOI: 10.1007/s10436-017-0308-x
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    References listed on IDEAS

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    Cited by:

    1. Berndsen, Ron, 2020. "Five Fundamental Questions on Central Counterparties," Other publications TiSEM 1f3bd844-92ab-4104-8f57-9, Tilburg University, School of Economics and Management.
    2. Tomasz R. Bielecki & Igor Cialenco & Shibi Feng, 2018. "A Dynamic Model of Central Counterparty Risk," Papers 1803.02012, arXiv.org.
    3. Tomasz R. Bielecki & Igor Cialenco & Shibi Feng, 2018. "A Dynamic Model Of Central Counterparty Risk," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 21(08), pages 1-34, December.

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    More about this item

    Keywords

    Counterparty risk; Aggregate risk; Central counterparty (CCP) clearing; Optimal risk-sharing; Search and Moral hazard;
    All these keywords.

    JEL classification:

    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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