Central Clearing and Systemic Risk

35 Pages Posted: 23 Dec 2019

See all articles by Nikolai Nowaczyk

Nikolai Nowaczyk

Quaternion Risk Management

Sharyn O'Halloran

Columbia University - School of International & Public Affairs

Date Written: December 8, 2019

Abstract

The G20's push towards central clearing changed the shape of the world's financial system: all standardized derivative contracts must now be cleared through central counterparties (CCPs). Despite considerable debate, the impact of central clearing nonetheless remains ambiguous and hard to measure as clearing regulations have been implemented alongside many other changes. In the present paper, we isolate the impact of CCPs by first representing all trade and risk relations of a financial system in a graph model. We then formalize clearing as an operator on those graphs and obtain sharp a priori bounds of its effect on total risk levels. Using numerical simulation, we then show how clearing alters the credit risk exposures of each bank depending on the netting structure of its trades. Further, we demonstrate how CCPs only reduce the total levels of risk in the system if their credit quality is substantially higher than that of the banks. We show, paradoxically, how the CCPs expose the system to substantial concentration risk and thereby undermine their initial purpose.

Keywords: Central Clearing, Systemic Risk, Financial Regulation, Graph Model, Simulation, Data Science, Credit Risk

JEL Classification: G01, G18, G28

Suggested Citation

Nowaczyk, Nikolai and O'Halloran, Sharyn, Central Clearing and Systemic Risk (December 8, 2019). Available at SSRN: https://ssrn.com/abstract=3500442 or http://dx.doi.org/10.2139/ssrn.3500442

Nikolai Nowaczyk (Contact Author)

Quaternion Risk Management ( email )

54 Fitzwilliam Square North
Dublin, D02X308
Ireland

Sharyn O'Halloran

Columbia University - School of International & Public Affairs ( email )

420 West 118th Street
New York, NY 10027
United States
(212) 854-3242 (Phone)
(212) 222-0598 (Fax)

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