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The Limits Of Central Counterparty Clearing: Collusive Moral Hazard And Market Liquidity

Author

Listed:
  • Thorsten V. Koeppl
Abstract
Can central counterparty (CCP) clearing control counterparty risk in the presence of risk taking that can aggravate such risk? When counterparty risk is not observable, I show that central clearing leads to higher collateral requirements for two different reasons. Without collusion about risk taking, a CCP offering diversification of risk cannot selectively forgo incentives for transactions that use collateral only for insurance. With collusion about risk taking, a CCP needs to charge collateral in line with the worst counterparty quality to control risk taking. Requiring more collateral reduces market liquidity and worsens incentives causing a feedback effect that amplifies collateral costs.

Suggested Citation

  • Thorsten V. Koeppl, 2013. "The Limits Of Central Counterparty Clearing: Collusive Moral Hazard And Market Liquidity," Working Paper 1312, Economics Department, Queen's University.
    • Handle: RePEc:qed:wpaper:1312
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    File URL: https://www.econ.queensu.ca/sites/econ.queensu.ca/files/qed_wp_1312.pdf
    File Function: First version 2013
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    References listed on IDEAS

    as
    1. Wagner, Wolf, 2010. "Diversification at financial institutions and systemic crises," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 373-386, July.
    2. Markus K. Brunnermeier & Lasse Heje Pedersen, 2009. "Market Liquidity and Funding Liquidity," The Review of Financial Studies, Society for Financial Studies, vol. 22(6), pages 2201-2238, June.
    3. Daniel Heller & Nicholas Vause, 2012. "Collateral requirements for mandatory central clearing of over-the-counter derivatives," BIS Working Papers 373, Bank for International Settlements.
    4. Thorsten Koeppl & Cyril Monnet, 2010. "The emergence and future of central counterparties," Working Papers 10-30, Federal Reserve Bank of Philadelphia.
    5. Bruno Biais & Florian Heider & Marie Hoerova, 2016. "Risk-Sharing or Risk-Taking? Counterparty Risk, Incentives, and Margins," Journal of Finance, American Finance Association, vol. 71(4), pages 1669-1698, August.
    6. Thorsten Koeppl & Cyril Monnet, 2006. "Central Counterparties," 2006 Meeting Papers 513, Society for Economic Dynamics.
    7. Koeppl, Thorsten & Monnet, Cyril & Temzelides, Ted, 2012. "Optimal clearing arrangements for financial trades," Journal of Financial Economics, Elsevier, vol. 103(1), pages 189-203.
    8. Bruno Biais & Florian Heider & Marie Hoerova, 2012. "Clearing, Counterparty Risk, and Aggregate Risk," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 60(2), pages 193-222, July.
    9. David Mills & Francesca Carapella, 2012. "Information insensitive securities: the benefits of central counterparties," 2012 Meeting Papers 1032, Society for Economic Dynamics.
    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. Radoslav Raykov, 2014. "Optimal Margining and Margin Relief in Centrally Cleared Derivatives Markets," Staff Working Papers 14-29, Bank of Canada.
    2. Jeannette Capel & Anouk Levels, 2014. "Collateral optimisation, re-use and transformation," DNB Occasional Studies 1205, Netherlands Central Bank, Research Department.
    3. Bulusu, Narayan & Guérin, Pierre, 2019. "What drives interbank loans? Evidence from Canada," Journal of Banking & Finance, Elsevier, vol. 106(C), pages 427-444.
    4. Wenqian Huang, 2019. "Central counterparty capitalization and misaligned incentives," BIS Working Papers 767, Bank for International Settlements.
    5. Albert Menkveld & Emiliano Pagnotta & Marius Andrei Zoican, 2016. "Does Central Clearing Affect Price Stability? Evidence from Nordic Equity Markets," Working Papers hal-01253702, HAL.
    6. Martin D. Gould & Nikolaus Hautsch & Sam D. Howison & Mason A. Porter, 2020. "Counterparty Credit Limits: The Impact of a Risk-Mitigation Measure on Everyday Trading," Applied Mathematical Finance, Taylor & Francis Journals, vol. 27(6), pages 520-548, November.
    7. Bank for International Settlements, 2019. "Establishing viable capital markets," CGFS Papers, Bank for International Settlements, number 62, december.
    8. Binbin Deng, 2017. "Counterparty risk, central counterparty clearing and aggregate risk," Annals of Finance, Springer, vol. 13(4), pages 355-400, November.
    9. Radoslav Raykov, 2016. "To Share or Not to Share? Uncovered Losses in a Derivatives Clearinghouse," Staff Working Papers 16-4, Bank of Canada.
    10. Carapella, Francesca & Monnet, Cyril, 2020. "Dealers’ insurance, market structure, and liquidity," Journal of Financial Economics, Elsevier, vol. 138(3), pages 725-753.
    11. Gaetano Antinolfi & Francesca Carapella & Francesco Carli, 2019. "Transparency and Collateral: The Design of CCPs' Loss Allocation Rules," Finance and Economics Discussion Series 2019-058, Board of Governors of the Federal Reserve System (U.S.).
    12. Gould, Martin D. & Hautsch, Nikolaus & Howison, Sam D. & Porter, Mason A., 2017. "Counterparty credit limits: An effective tool for mitigating counterparty risk?," CFS Working Paper Series 581, Center for Financial Studies (CFS).

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    More about this item

    Keywords

    CCP Clearing; Counterparty Risk; Moral Hazard; Collateral; Market Liquidity;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness

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