Research Discussion Paper – RDP 2016-07 The Efficiency of Central Clearing: A Segmented Markets Approach

This paper examines the role of central clearing in a consumption-based asset pricing model with incomplete markets and default. We show that central clearing can increase welfare by insuring against counterparty credit risk when private insurance markets are incomplete. We find that the gains from central clearing are largest when there is a higher probability of default and when over-the-counter derivative contracts provide an effective hedge against underlying risk. However, the potential gains are sensitive to the level of margin required by the central counterparty. When margin requirements are not set optimally, central clearing can result in too much or too little financial trade.