Central Counterparties and Strategic Reduction of Systemic Risk

26 Pages Posted: 22 Feb 2016

See all articles by James T. E. Chapman

James T. E. Chapman

Government of Canada - Bank of Canada

Tsz-Nga Wong

Washington University in St Louis

Date Written: August 2013

Abstract

This paper studies a dynamic network economy, where risk averse traders trade multi-laterally over the counter but cannot commit to fulfil their short positions. We show that, although the level of trade is below the first-best, bilateral clearing with collateral can provide an allocation superior to those without collateral. However, with use of collateral, the optimal bilateral clearing contract leads to multiple equilibria, one of which is a scenario of systemic default where defaulting one’s trading partner will trigger the victim to default his trading partners, and so on, causing the spread of contagious default. We show that a simple arrangement with central counterparty clearing (CCP) can eliminate the systemic risk of default contagion, and raise the level of trade, but at the cost of higher level of collateral. We show that whether CCP is essential depends on the opportunity cost of collateral, the discount rate, and the traders’ endowment and risk aversion.

Keywords: over-the-counters search model, dynamic contract, central counterparty, settlement systems, interbank markets, multi-lateral trade network, default

JEL Classification: G01, G12 G18, E42

Suggested Citation

Chapman, James T. E. and Wong, Tsz-Nga, Central Counterparties and Strategic Reduction of Systemic Risk (August 2013). Melbourne Business School, 2016 Financial Institutions, Regulation & Corporate Governance (FIRCG) Conference, Available at SSRN: https://ssrn.com/abstract=2736023 or http://dx.doi.org/10.2139/ssrn.2736023

James T. E. Chapman (Contact Author)

Government of Canada - Bank of Canada ( email )

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

Tsz-Nga Wong

Washington University in St Louis ( email )

One Brookings Drive
St. Louis, MO 63130
United States

HOME PAGE: http://sites.google.com/site/tszngawong/

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