Counterparty Exposures and Collateral Requirements under Bilateral and Central Clearing

Category: Finance Brown Bag Seminar
When: 03 June 2020
, 14:00
 - 15:00
Where: online
Speaker: Xu Liu (Goethe University)

Author: Xu Liu (Goethe University Frankfurt)

Title: Counterparty Exposures and Collateral Requirements under Bilateral and Central Clearing

Abstract: In this paper, I develop a model of over-the-counter derivatives trade with two possible clearing mechanisms: bilateral and central clearing. Under bilateral clearing, I show that the level of trade in equilibrium is strictly lower than the socially optimal level in the presence of individual counterparty exposures. Due to limited commitment, collateral must be used to hedge against counterparty defaults in equilibrium. Nevertheless, the equilibrium can still experience a notion of complete default. With a central counterparty (CCP) that mutualizes individual counterparty exposures, equilibrium default can be prevented. Yet, central clearing may come with a higher level of collateral requirement if the CCP itself is a prudent player in the OTC market, and there is a trade-off between equilibrium volume of trade and collateral usage under central clearing. Only when we treat the CCP as a risk-neutral clearing tool, central clearing can achieve both higher trade volume and lower collateral usage.

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