Reshaping the Financial Network: Value Redistribution and Externalities in Central Clearing
72 Pages Posted: 7 Jul 2019 Last revised: 18 Jan 2021
Date Written: January 1, 2021
Abstract
The market infrastructure reform carried out in the aftermath of the 2008 financial crisis mandates the central clearing of standardized over-the-counter derivatives. We investigate how this reform can impact on the valuation of derivative contracts and how it can lead to unintended value redistribution effects among market participants. The transition to central clearing changes both the counterparty risk and the funding costs associated with a derivative position. By developing a theoretical model of derivative contract valuation, we clarify how these changes affect the expected value adjustments for a particular dealer and identify the three channels of value redistribution. Moreover, we find that, through these value adjustments, mutualization of risks and collateral in a central clearing counterparty can lead to externalities among the members.
Keywords: Central Clearing Counterparty (CCP), OTC derivatives, financial networks, systemic risk, market structure
JEL Classification: G23, G01, G10
Suggested Citation: Suggested Citation