Value redistribution and externalities in central clearing

Figure 1, panel a, provides a stylized illustration of a bilateral market where dealers are exposed to each other via derivative contracts. For instance, Dealer 1 should receive 20 from Dealer 3 and pay 40 to Dealer 2; therefore, Dealer 1 has a net position of -20. As figure 1, panel b, illustrates, the introduction of a CCP significantly changes the liability structure in the market. Dealers are no longer directly exposed to each other via derivative contracts but become members of the CCP.

In our working paper (joint with Marco D’Errico and Stefano Battiston), we argue that this infrastructural reform, intended to improve financial stability, is not neutral in terms of valuation. We introduce a minimal theoretical model and show that due to counterparty risk and collateral costs, the impact on valuation, for a particular dealer, depends, in particular, on its credit quality and the size of its portfolio. Moreover, mutualization of funds and risks in a CCP leads to externalities between members, in the sense that the valuation of a contract depends on the characteristics of the CCP and all its members. We identify three channels at the root of this shift in valuation: netting, loss-mutualization, and funding costs.

Netting and counterparties’ credit quality

Netting allows offsetting the value of multiple positions between counterparties and eliminates the same nominal amount of assets and liabilities. However, for a relatively high-quality counterparty, the probability to fulfill liabilities is higher than the probability to receive the same amount of assets. Therefore, we show that netting increases the contract value for relatively high-quality counterparties. Due to mutualization and the CCP’s additional “skin in the game” capital, a CCP is likely to have a higher credit quality than any single member. Therefore, the credit quality effect of netting diminishes members’ incentives to net once they are in a CCP. We also show that a deal arranged between two CCP members could lead to a positive netting effect for both counterparties if it increases the net position of a relatively risky member and decreases that of a relatively safe member. The resulting deterioration of the CCP quality affects all the other CCP members in the form of negative externalities.

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Network view on loss-mutualization

Since dealers are not risk-free, a CCP requires them to post collateral in the form of initial and variation margin and default fund contributions. Figure 2 illustrates a standard risk-management scheme of a CCP, often known as a “default waterfall.”

Figure 2: “Default waterfall” structure and a network of expected exposures

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