Central Counterparties and Strategic Reduction of Systemic Risk

Abstract

This paper studies a dynamic network economy, where risk averse traders trade multi-laterally over the counter but cannot commit to fulfil their short positions. We show that, although the level of trade is below the first-best, bilateral clearing with collateral can provide an allocation superior to those without collateral. However, with use of collateral, the optimal bilateral clearing contract leads to multiple equilibria, one of which is a scenario of systemic default where defaulting one’s trading partner will trigger the victim to default his trading partners, and so on, causing the spread of contagious default. We show that a simple arrangement with central counterparty clearing (CCP) can eliminate the systemic risk of default contagion, and raise the level of trade, but at the cost of higher level of collateral. We show that whether CCP is essential depends on the opportunity cost of collateral, the discount rate, and the traders’ endowment and risk aversion.