Central clearing of OTC derivatives: Bilateral vs multilateral netting

Cont Rama () and Kokholm Thomas
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Cont Rama: Department of Mathematics & Institute of Quantititive Finance, Imperial College, London SW8 2AZ, United Kingdom
Kokholm Thomas: Department of Economics and Business, Aarhus University, Fuglesangs Allé 4, 8210 Aarhus, Denmark

Statistics & Risk Modeling, 2014, vol. 31, issue 1, 3-22

Abstract: We study the impact of central clearing of over-the-counter (OTC) transactions on counterparty exposures in a market with OTC transactions across several asset classes with heterogeneous characteristics. The impact of introducing a central counterparty (CCP) on expected interdealer exposure is determined by the tradeoff between multilateral netting across dealers on one hand and bilateral netting across asset classes on the other hand. We find this tradeoff to be sensitive to assumptions on heterogeneity of asset classes in terms of `riskyness' of the asset class as well as correlation of exposures across asset classes. In particular, while an analysis assuming independent, homogeneous exposures suggests that central clearing is efficient only if one has an unrealistically high number of participants, the opposite conclusion is reached if differences in riskyness and correlation across asset classes are realistically taken into account. We argue that empirically plausible specifications of model parameters lead to the conclusion that central clearing does reduce interdealer exposures: the gain from multilateral netting in a CCP overweighs the loss of netting across asset classes in bilateral netting agreements. When a CCP exists for interest rate derivatives, adding a CCP for credit derivatives is shown to decrease overall exposures. These findings are shown to be robust to the statistical assumptions of the model as well as the choice of risk measure used to quantify exposures.

Keywords: Central clearing; networks; central counterparty; CCP; regulation; collateral; systemic risk; netting; OTC derivatives; OTC markets; risk management; Central clearing; networks; central counterparty; CCP; regulation; collateral; systemic risk; netting; OTC derivatives; OTC markets; risk management (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (7)

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DOI: 10.1515/strm-2013-1161

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