The Design of a Central Counterparty

57 Pages Posted: 16 Sep 2021 Last revised: 11 Sep 2022

Date Written: September 1, 2021

Abstract

This working paper was written by John Kuong (INSEAD) and Vincent Maurin (Stockholm School of Economics).

This paper studies the benefits of central clearing and the design of a central counterparty (CCP) with an optimal contracting approach. Investors sign contracts to hedge an underlying exposure. There is counterparty risk because investors can default on the contract due to idiosyncratic shocks and moral hazard. Mutualization of losses can thus hedge against counterparty risk but demands collateral for preventing moral hazard. The optimal contract involves loss mutualization, which requires central clearing, only when the cost of collateral is intermediate. Furthermore, as loss mutualization dilutes investors’ incentives to monitor their counterparties, a third-party CCP can emerge as a centralized monitor and is given a first-loss, equity tranche as incentive compensation. Our results endogenize key features of the default resolution process, known as “default waterfall”, in a CCP. Finally, we show that larger user base of a contract favors central clearing (over bilateral trading) and clearing with third-party CCP (over member owned CCP).

Keywords: CCP, Financial Stability, Contracting, Market Design.

JEL Classification: D47, D86, G23.

Suggested Citation

Research, Hong Kong Institute for Monetary and Financial, The Design of a Central Counterparty (September 1, 2021). Hong Kong Institute for Monetary and Financial Research (HKIMR) Research Paper WP No. 21/2021, Swedish House of Finance Research Paper No. 21-17, Proceedings of Paris December 2021 Finance Meeting EUROFIDAI - ESSEC, Available at SSRN: https://ssrn.com/abstract=3923342 or http://dx.doi.org/10.2139/ssrn.3923342

Hong Kong Institute for Monetary and Financial Research (Contact Author)

Hong Kong Institute for Monetary and Financial Research ( email )

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