RDP 2016-07: The Efficiency of Central Clearing: A Segmented Markets Approach 5. Conclusion and Discussion

This paper provides a tractable framework for assessing the efficiency of mandatory clearing and optimal margin requirements using a consumption-based asset pricing model with market segmentation. We view it as a useful first step in understanding how trader behaviour might respond to different market structures and for evaluating different public policy interventions designed to improve welfare and stability in OTC derivative markets.

Our analysis suggests that:

• Central clearing can improve welfare by mitigating counterparty credit risk in OTC derivatives markets.
• The benefits of central clearing are higher the higher the probability of default and the stronger the correlation between the OTC derivatives contract and the underlying risk – that is, when OTC derivatives are an effective hedge.
• In the absence of initial margin, the moral hazard problem that arises from mutualising default losses through a CCP's default fund is large. This inefficiency can outweigh the benefits from central clearing and worsens as the probability of default rises.
• Initial margin requirements are an effective tool to mitigate this externality and are a good substitute for state-contingent taxes. If margin requirements are set optimally, central clearing is always welfare improving. Optimal margin requirements are higher when default is more likely.
• The optimal level of central clearing is sensitive to how margin requirements are calibrated.