The Pitfalls of Central Clearing in the Presence of Systematic Risk
54 Pages Posted: 6 Nov 2018 Last revised: 22 May 2019
Date Written: May 20, 2019
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 a reasonable number of clearing members. We show that this is typically not the case by explicitly considering systematic risk in derivative prices. Central clearing increases counterparty risk exposure particularly in cases of extreme events, small clearing margins, and directionality (i.e., nonzero net positions) in derivative portfolios. Our results are consistent with market participants' reluctance to clear derivative trades in the absence of a clearing obligation and have substantial implications for derivatives market design.
Keywords: Central Clearing, Counterparty Risk, Systematic Risk, OTC markets, Derivatives, Margin
JEL Classification: G01, G14, G18, G28
Suggested Citation: Suggested Citation