Transparency and Collateral: The Design of CCPs' Loss Allocation Rules

102 Pages Posted: 22 Oct 2019

See all articles by Gaetano Antinolfi

Gaetano Antinolfi

Washington University in St. Louis

Francesca Carapella

Board of Governors of the Federal Reserve System

Francesco Carli

Deakin University

Date Written: 2019-08

Abstract

This paper adopts a mechanism design approach to study optimal clearing arrangements for bilateral financial contracts in which an assessment of counterparty risk is crucial for efficiency. The economy is populated by two types of agents: a borrower and lender. The borrower is subject to limited commitment and holds private information about the severity of such lack of commitment. The lender can acquire information at a cost about the commitment of the borrower, which affects the assessment of counterparty risk. When truthful revelation by the borrower is not incentive compatible, the mechanism designer optimally trades off the value of information about the lack of commitment of the borrower with the cost of incentivizing the lender to acquire such information. Central clearing of these financial contracts through a central counterparty (CCP) allows lenders to mutualize their counterparty risks, but this insurance may weaken incentives to acquire and reveal informatio n about such risks. If information acquisition is incentive compatible, then lenders choose central clearing. If it is not, they may prefer bilateral clearing to prevent strategic default by borrowers and to economize on costly collateral. Central clearing is analyzed under different institutional features observed in financial markets, which place different restrictions on the contract space in the mechanism design problem. The interaction between the costly information acquisition and the limited commitment friction differs significantly in each clearing arrangement and in each set of restrictions. This results in novel lessons about the desirability of central versus bilateral clearing depending on traders' characteristics and the institutional features defining the operation of the CCP.

Keywords: Limited commitment, Central counterparties, Collateral

JEL Classification: G10, G14, G20, G23

Suggested Citation

Antinolfi, Gaetano and Carapella, Francesca and Carli, Francesco, Transparency and Collateral: The Design of CCPs' Loss Allocation Rules (2019-08). FEDS Working Paper No. 2019-058, Available at SSRN: https://ssrn.com/abstract=3473042 or http://dx.doi.org/10.17016/FEDS.2019.058

Gaetano Antinolfi (Contact Author)

Washington University in St. Louis ( email )

One Brookings Drive
Campus Box 1208
Saint Louis, MO MO 63130-4899
United States

Francesca Carapella

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Francesco Carli

Deakin University ( email )

75 Pigdons Road
Victoria, Victoria 3216
Australia

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