Abstract: This paper studies the benefits of central clearing and the design of a central counterparty (CCP) with an optimal contracting approach. Investors sign contracts to hedge an underlying exposure. There is counterparty risk because investors can default on the contract due to idiosyncratic shocks and moral hazard. Mutualization of losses can thus hedge against counterparty risk but demands collateral for preventing moral hazard. The optimal contract involves loss mutualization, which requires central clearing, only when the cost of collateral is intermediate. Furthermore, as loss mutualization dilutes investors' incentives to monitor their counterparties, a third-party CCP can emerge as a centralized monitor and is given a first-loss, equity tranche as incentive compensation. Our results endogenize key features of the default resolution process, known as ``default waterfall", in a CCP. Finally, we show that larger user base of a contract favours central clearing (over bilateral trading) and clearing with third-party CCP (over member-owned CCP).
Joshua H Katz (University of Illinois)
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