The Emergence and Future of Central Counterparties

Abstract

We explain why central counterparties (CCPs) emerged historically. With standardized contracts, it is optimal to insure counterparty risk by clearing those contracts through a CCP that uses novation and mutualization. As netting is not essential for these services, it does not explain why CCPs exist. In over-the-counter markets, as contracts are customized and not fungible, a CCP cannot fully guarantee contract performance. Still, a CCP can help: As bargaining leads to an inefficient allocation of default risk relative to the gains from customization, a transfer scheme is needed. A CCP can implement it by offering partial insurance for customized contracts.

Peer Monitoring via Loss Mutualization

“…The possibility to pool and diversify idiosyncratic default risk through a CCP provides a missing insurance market, and improves the allocation of risk among traders. For instance, this point is raised in Carapella and Mills (2012), Biais et al (2012), Koeppl and Monnet (2013). Carapella and Mills (2012), Biais et al (2012) and Antinolfi et al (2014) all point out that a CCP reduces traders' incentive to acquire information on counter party risk.…”

Clearing, Counterparty Risk and Aggregate Risk

“…Our analysis is related to Koeppl and Monnet (2010), who also consider the mutualization bene…t of CCPs. But the market frictions they analyze di¤er from ours.…”

“…Our focus is on optimal contracts, attaining information constrained Pareto optimality, and on trades that are observable and contractible. Unlike Koeppl and Monnet (2010), we assume that protection buyers must exert e¤ort to screen and monitor counterparties (and we also consider the case in which this e¤ort is unobservable). Our conclusion that, to preserve incentives, protection buyers should not be fully insured against counterparty risk is the opposite of what Koeppl and Monnet (2010) conclude.…”

The Pitfalls of Central Clearing in the Presence of Systematic Risk

“…To mitigate such systemic risks from derivatives, regulators worldwide promoted the use of Central Clearing Counterparties (CCPs) to centrally clear OTC derivatives transactions (G20 (2009)). 1 A primary task of CCPs is to insure counterparty risk (Koeppl and Monnet (2010)), which is especially needed during extreme negative macroeconomics conditions. In this paper, we examine how central clearing affects the level and distribution of counterparty risk from a market participant's perspective.…”