Does a Central Clearing Counterparty Reduce Counterparty Risk?

31 Pages Posted: 23 Feb 2009 Last revised: 28 Apr 2011

Darrell Duffie

Stanford University - Graduate School of Business; National Bureau of Economic Research (NBER)

Haoxiang Zhu

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Date Written: April 27, 2011

Abstract

We show whether central clearing of a particular class of derivatives lowers counterparty risk. For plausible cases, adding a central clearing counterparty (CCP) for a class of derivatives such as credit default swaps reduces netting efficiency, leading to an increase in average exposure to counterparty default. Further, clearing different classes of derivatives in separate CCPs always increases counterparty exposures relative to clearing the combined set of derivatives in a single CCP. We provide theory as well as illustrative numerical examples of these results that are calibrated to notional derivatives position data for major banks.

Keywords: central clearing, netting efficiency, counterparty risk, over-the-counter derivatives

JEL Classification: G01, G14, G18, G28

Suggested Citation

Duffie, Darrell and Zhu, Haoxiang, Does a Central Clearing Counterparty Reduce Counterparty Risk? (April 27, 2011). Rock Center for Corporate Governance at Stanford University Working Paper No. 46; Stanford University Graduate School of Business Research Paper No. 2022. Available at SSRN: https://ssrn.com/abstract=1348343 or http://dx.doi.org/10.2139/ssrn.1348343

James Darrell Duffie (Contact Author)

Stanford University - Graduate School of Business ( email )

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National Bureau of Economic Research (NBER)

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Haoxiang Zhu

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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Cambridge, MA 02142
United States

HOME PAGE: http://www.mit.edu/~zhuh

National Bureau of Economic Research (NBER) ( email )

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Cambridge, MA 02138
United States

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