Does a Central Clearing Counterparty Reduce Counterparty Risk?

by Darrell Duffie of Stanford University, and
Haoxiang Zhu of Stanford University

July 24, 2010

Abstract: We show whether central clearing of a particular class of derivatives lowers counterparty risk. For plausible cases, adding a central clearing counterparty (CCP) for a class of derivatives such as credit default swaps reduces netting efficiency, leading to an increase in average exposure to counterparty default. Further, clearing different classes of derivatives in separate CCPs always increases counterparty exposures relative to clearing the combined set of derivatives in a single CCP. We provide theory as well as illustrative numerical examples of these results that are calibrated to notional derivatives position data for major banks.

JEL Classification: G1, G14, G18, G28.

Keywords: central clearing, netting efficiency, counterparty risk, over-the-counter derivatives.

Download paper (170K PDF) 30 pages

Related reading: " Are We Building the Foundations for the Next Crisis Already? The case of central clearing"
" OTC Derivatives and Central Clearing: Can all transactions be cleared?"