Central clearing and loss allocation rules

Abstract

I study the effects of central clearing in over-the-counter derivative markets in a simple model of derivative trading. When risk-sharing is limited by moral hazard problems facing protection sellers, central counterparties (CCPs) facilitate risk-sharing by mutualizing idiosyncratic counterparty risk and economizing on costly margin calls. When clearing members’ defaults are correlated, CCPs mutualize losses across its members. CCPs facing their own moral hazard problems can be induced to manage risk prudently by absorbing losses with CCP capital. A clearing fee can compensate CCPs for raising costly capital but may be prohibitively costly, warranting a return to bilateral trading.