Adverse Selection Effect of CCP Haircuts

Abstract

Centralized clearing is becoming widespread, making Central Counterparties (CCPs) systemically important. Using a novel transaction-level dataset of centrally cleared and over-the-counter (OTC) repo, I show that high CCP haircuts drive low-risk borrowers away from the centrally cleared to the OTC market. This happens because an increase in CCP haircuts applies to all participants uniformly, but safer borrowers are likelier to switch to borrowing OTC. This effect is stronger among collateral-constrained borrowers. While conventional wisdom holds that high haircuts enhance CCP stability, I demonstrate that they can induce adverse selection in the CCP market, potentially undermining this stability instead.

Keywords: CCP, Central Counterparties, OTC, Haircut, Collateral Requirements, Repo

JEL Classification: G21, G23, G28, G32