To Fully Net or Not to Net: Adverse Effects of Partial Multilateral Netting

Abstract

We study a financial network where forced liquidations of an illiquid asset have a negative impact on its price, thus reinforcing network contagion. We prove uniqueness of the clearing asset price and liability payments under no, partial, and full multilateral netting of interbank liabilities. We show that partial versus full multilateral netting increases bank shortfall, and reduces clearing asset price and aggregate bank surplus. We also show that partial multilateral netting can be worse than no netting at all.

Compressing Over-the-Counter Markets

“…Recent work by Veraart (2019) and Schuldenzucker et al (2018) adopted the framework introduced in this paper to characterize capital conditions mapping such risk redistribution into an increase in systemic risk. These results are analogous to the adverse effect of partial netting in central clearing shown by Amini et al (2016). In general, Donaldson and Piacentino (2018) show that maintaining offsetting claims may be rational for banks because of the capacity to dilute transfers.…”

“…Duffie et al (2015), Glasserman et al (2015), and Ghamami and Glasserman (2017) study the impact of clearing on collateral and capital requirements and show that trading and liquidation costs can be higher or lower depending on the proliferation of CCPs and the extent to which netting opportunities can be exploited. In addition, Amini et al (2016) show that netting inefficiencies resulting from partial clearing may be more detrimental, in terms of bank shortfall, than no netting at all. The results of this paper on the effect of multiple CCPs provide a quantitative assessment of the loss in netting efficiencies and its impact on market excess.…”

Central Counterparty Exposure in Stressed Markets

“…Capponi et al (2015) analyze the endogenous build-up of asset concentration due to central clearing. Amini et al (2015) investigate partial netting for a subset of liabilities in a network setting that accounts for knock-on effects and asset liquidation effects. Glasserman et al (2015) compare margining in dealer markets and a centrally cleared market.…”

Debt Swapping for Risk Mitigation in Financial Networks

“…Note that the swap in the original version of this network is not positive in the worst-sum case, since a shock of size ∈ (0, 2 3 ) is harmless to 2 before the swap ( 2 can still fulfill its obligations), but it reduces the assets of 2 after the swap. This value 2 3 turns out to be a crucial threshold in this system, since this is the amount of loss after which 2 starts making less payments. As such, for our proof, let us consider a modified version of Figure 8 where we also increase the assets of 1 by this amount, i.e.…”

“…Bank 2 loses no funds until = 2 3 , and then its funds drop linearly until = 2; at this point, it only receives the 2 3 units of money that are indirectly coming from 1 . From this point, its assets remain fixed for another 2 3 units of shock (while the extra funds of 1 are depleted), and then they drop linearly to 0. This defines the function (0, 2) − ( 23 , 2) − (2, 2 3 ) − (2 + 2 3 , 2 3 ) − (4 + 2 3 , 0).…”