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

  • Thorsten V. Koeppl

    ()

    (Queen's University)

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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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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  1. David Mills & Francesca Carapella, 2012. "Information insensitive securities: the benefits of central counterparties," 2012 Meeting Papers 1032, Society for Economic Dynamics.
  2. Koeppl, Thorsten & Monnet, Cyril & Temzelides, Ted, 2012. "Optimal clearing arrangements for financial trades," Journal of Financial Economics, Elsevier, vol. 103(1), pages 189-203.
  3. Koeppl, Thorsten V. & Monnet, Cyril, 2008. "Central counterparties," CFS Working Paper Series 2008/42, Center for Financial Studies (CFS).
  4. Lasse Heje Pederson & Markus K Brunnermeier, 2007. "Market Liquidity and Funding Liquidity," FMG Discussion Papers dp580, Financial Markets Group.
  5. Wagner, Wolf, 2010. "Diversification at financial institutions and systemic crises," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 373-386, July.
  6. 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.
  7. Biais, Bruno & Heider, Florian & Hoerova, Marie, 2012. "Risk-sharing or risk-taking? Counterparty risk, incentives and margins," Working Paper Series 1413, European Central Bank.
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