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Counterparty risk, central counterparty clearing and aggregate risk

Binbin Deng ()
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Binbin Deng: Compass Lexecon

Authors registered in the RePEc Author Service: 邓彬斌 ()

Annals of Finance, 2017, vol. 13, issue 4, 355-400

Abstract: Abstract I construct a model of bilateral trading of over-the-counter (OTC) derivatives to study the performance of central counterparty (CCP) clearing. I first show how buyers are exposed to counterparty risk under bilateral clearing. I then show how a CCP can fully insure against counterparty risk through risk-mutualization and achieve full idiosyncratic risk-sharing among market participants. I further demonstrate the impact of aggregate risk on CCP clearing and illustrate a scenario in which the CCP fails to provide full insurance against counterparty risk and full idiosyncratic risk-sharing collapses under severe aggregate risk. To insure against aggregate risk and retain full idiosyncratic risk-sharing, sellers’ capital resource is important on top of CCP mutualization. Finally, I allow buyers to costly search for sellers and study the implications of optimal search effort. I show how a moral hazard problem can arise if effort is unobservable, in which case full CCP insurance against counterparty risk is no longer optimal.

Keywords: Counterparty risk; Aggregate risk; Central counterparty (CCP) clearing; Optimal risk-sharing; Search and Moral hazard (search for similar items in EconPapers)
JEL-codes: D53 D82 G18 G23 (search for similar items in EconPapers)
Date: 2017
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