Can the Financial Markets Privately Regulate Risk? The Development of Derivatives Clearing Houses and Recent Over-the-Counter Innovations

Abstract

This paper explores how organization and contract design has evolved to address regulatory challenges in risk management. In the early part of the century, futures exchanges responded to credit risks by developing clearing houses that act as guarantors. The liability structure of the clearing house involves mutualization of risks through "partial permanent" integration of the exchange members. Bank clearing houses historically involved "contingent" integration and risk mutualization during panics. Recent organizational innovations have allowed the risk-control benefits of the clearing house to be replicated in the decentralized over-the-counter derivatives markets. Credit rating agencies and advances in risk modeling are key to permitting the recent "dis-integration," which has implications for the scope of public versus private regulation in banking and financial markets.

JEL Classification: L22, G28, K22, N20