Abstract
We study the optimal design of clearing systems, focusing on counterparty risk insurance and prevention. We study whether decentralized clearing improves on no clearing, and whether centralized clearing generates further improvement. We analyze how counterparty risk should be allocated, whether traders should be fully insured against that risk, and how moral-hazard affects the optimal allocation of risk. The main advantage of centralized clearing is the mutualization of counterparty risk. We show, however, that the improved risk-sharing brought about by centralized clearing can induce greater risk-taking, even in the first-best. Furthermore, while mutualization is useful to share idiosyncratic risk, it cannot provide insurance against aggregate risk. When the latter is significant, it is necessary that protection buyers exert effort to find robust counterparties. With moral hazard, this requires that they retain some exposure to counterparty risk.
Reference
Bruno Biais, Florian Heider, and Marie Hoerova, Clearing, counterparty risk and aggregate risk, 2011.
Published in
2011