The Economics of Clearing in Derivatives Markets: Netting, Asymmetric Information, and the Sharing of Default Risks Through a Central Counterparty

TLDR

Credit derivatives have been a major focus of scrutiny and criticism during the financial crisis, prompting regulators to propose central clearing to share default risk. An economic comparison shows that central clearing of credit derivatives may worsen information asymmetry and could raise systemic risk rather than reduce it.

Abstract

Credit derivatives have received intense scrutiny -- and criticism -- as a major contributor to the ongoing financial crisis. In response, regulators have proposed requiring the formation of a central clearinghouse to share default risk on these contracts. A comparative economic analysis of the costs and benefits of alternative default risk sharing mechanisms casts considerable doubt on the advisability of central clearing of credit derivatives. These products are likely to be subject to severe information asymmetry problems regarding their value, risk, and the creditworthiness of those who trade them, and these information asymmetries are likely to be less severe in bilateral markets than in centrally cleared systems. Moreover, although regulators have argued that clearing would reduce systemic risk, a more complete analysis demonstrates that clearing could actually increase risks to the broader financial system.