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

Author

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  • 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.

Suggested Citation

  • Thorsten V. Koeppl, 2013. "The Limits of Central Counterparty Clearing: Collusive Moral Hazard and Market Liquidity," Working Papers 1312, Queen's University, Department of Economics.
  • Handle: RePEc:qed:wpaper:1312
    as

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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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    References listed on IDEAS

    as
    1. Wagner, Wolf, 2010. "Diversification at financial institutions and systemic crises," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 373-386, July.
    2. Markus K. Brunnermeier & Lasse Heje Pedersen, 2009. "Market Liquidity and Funding Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 22(6), pages 2201-2238, June.
    3. Daniel Heller & Nicholas Vause, 2012. "Collateral requirements for mandatory central clearing of over-the-counter derivatives," BIS Working Papers 373, Bank for International Settlements.
    4. Bruno Biais & Florian Heider & Marie Hoerova, 2016. "Risk-Sharing or Risk-Taking? Counterparty Risk, Incentives, and Margins," Journal of Finance, American Finance Association, vol. 71(4), pages 1669-1698, August.
    5. Koeppl, Thorsten V. & Monnet, Cyril, 2010. "The Emergence and Future of Central Counterparties," Queen's Economics Department Working Papers 273740, Queen's University - Department of Economics.
    6. Bruno Biais & Florian Heider & Marie Hoerova, 2012. "Clearing, Counterparty Risk, and Aggregate Risk," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 60(2), pages 193-222, July.
    7. David Mills & Francesca Carapella, 2012. "Information insensitive securities: the benefits of central counterparties," 2012 Meeting Papers 1032, Society for Economic Dynamics.
    8. Koeppl, Thorsten & Monnet, Cyril & Temzelides, Ted, 2012. "Optimal clearing arrangements for financial trades," Journal of Financial Economics, Elsevier, vol. 103(1), pages 189-203.
    9. Thorsten Koeppl & Cyril Monnet, 2006. "Central Counterparties," 2006 Meeting Papers 513, Society for Economic Dynamics.
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    Citations

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    Cited by:

    1. Radoslav Raykov, 2014. "Optimal Margining and Margin Relief in Centrally Cleared Derivatives Markets," Staff Working Papers 14-29, Bank of Canada.
    2. Jeannette Capel & Anouk Levels, 2014. "Collateral optimisation, re-use and transformation," DNB Occasional Studies 1205, Netherlands Central Bank, Research Department.
    3. Albert Menkveld & Emiliano Pagnotta & Marius Andrei Zoican, 2016. "Does Central Clearing Affect Price Stability? Evidence from Nordic Equity Markets," Working Papers hal-01253702, HAL.
    4. repec:kap:annfin:v:13:y:2017:i:4:d:10.1007_s10436-017-0308-x is not listed on IDEAS

    More about this item

    Keywords

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

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness

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