Journal of Financial Market Infrastructures

When do central counterparties enhance market stability?

David Marshall, Ivana Ruffini and Dominic Anene

  • A liquidity-challenged clearing member derives no benefit from making a partial payment to the central counterparty (CCP).
  • Typically in the literature, the resources of a defaulter are assumed to be distributed to creditors on a pro-rata basis, we explain why that pro-rata assumption is an unrealistic way to model distribution of resources of defaulted clearing members in derivatives markets.
  • The stability benefits of central clearing are higher for networks with large gains from multilateral netting, so networks with large redundancies in gross exposures become less fragile by moving to central clearing.
  • The advantages of a clearing mandate depend on the degree of payment flexibility one can assume for bilateral market participants - a market structure that encourages partial payments when liquidity is stressed may have stability advantages.

We conduct a head-to-head comparison of central and bilateral clearing to evaluate the impact of market structure on market stability. We introduce the concept of “all-or-nothing” payouts, whereby counterparties are assumed to either discharge their obligations in full or not at all. We argue that this assumption appropriately reflects payout incentives in centrally cleared markets and, in times of market stress, could characterize bilateral markets as well. If this all-or-nothing assumption is made for both structures, we find that central clearing enhances network stability in the event of a severe shock. Our results are ambiguous for small shocks. In addition, we find that the stability benefits of central clearing are higher for networks with large potential gains from multilateral netting. In contrast, when we replace the all-or-nothing assumption with the pro-rata payout assumption generally made in the literature, we find that the bilateral structure is more stable than the centrally cleared structure. Thus, our assessment of the relative benefits of central clearing depends on whether or not defaulters in the bilateral market are likely to make partial payments under stressed conditions.

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