Be Careful What You Wish For: Cost of collateral, liquidity and incentives with central counterparty clearing

by Thorsten V. Koeppl of Queen's University

July 26, 2011

Abstract: Central counterparty (CCP) clearing - as defined by offering a substitution of counterparty through novation - offers collateral savings by diversifying default risk. It can, however, upset contracts where either collateral is used or market discipline is applied to ensure a low probability of default in the presence of moral hazard. Such discipline allows to save on costly collateral that is used as an incentive device. Consequently, CCP clearing can lead to an increase in collateral costs, even though unit costs of collateral with such clearing fall and default risk remains unchanged. This is the case whenever CCP clearing decreases liquidity in financial markets sufficiently, so that market participants cannot rely on reputation as an incentive mechanism anymore. I show that CCP clearing offers the largest benefits in situations where reputational concerns matter the least, i.e. when (i) liquidity is large and (ii) moral hazard severe.

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