The Pitfalls of Central Clearing in the Presence of Systematic Risk
73 Pages Posted: 6 Nov 2018 Last revised: 4 Jan 2019
Date Written: December 20, 2018
Through the lens of market participants' objective to minimize counterparty risk exposure, we show that central clearing is not the optimal choice in various realistic situations. Previous studies suggest that central clearing is beneficial in the presence of sufficiently many clearing members. We show that this is typically not the case, due to correlation of prices across and within derivative classes (i.e., systematic risk), loss sharing among clearing members, and small clearing margins. Our results are consistent with market participants' reluctance to clear derivative trades in the absence of a clearing obligation and has substantial implications for derivatives market design.
Keywords: Central Clearing, Counterparty Risk, Systematic Risk, OTC markets, Derivatives, Loss Sharing, Collateral, Margin
JEL Classification: G01, G14, G18, G28
Suggested Citation: Suggested Citation