Reshaping the Financial Network : Externalities of Central Clearing and Systemic Risk

Meant to limit systemic risk and ensure transparency, the mandate to clear specific transactions via central clearing counterparties (CCP) is at the heart of the following the crisis regulatory reforms and leads to the reshaping of the over-thecounter (OTC) network. Taking a network perspective, we show how the transition to central clearing effects the expected value of a derivative contract and thereby redistributes wealth among market participants. We find that the realistic assumptions of counterparty risk and costly collateral create distortions in the expected value of a symmetric derivative contract, which depend on the structure of the market and arise on three levels: i) credit quality distortion of netting, ii) loss-mutualisation, and iii) funding costs. Because of mutualisation of risks and funds in a CCP, these distortions lead to externalities between CCP members. Moreover, we find that even though a CCP interposes itself between bilateral counterparties, the real insulation from the counterparty risk does not always hold. We derive a threshold value on a CCP’s “skin in the game” capital, below which expected exposures between members form a fully connected network. The threshold is hit precisely in times of distress, that might further increase systemic risk. Our work offers a simple network framework for further assessments of the policy implications of mandatory central clearing, including its impact on the relations between market participants, their incentives, and systemic risk.