Bilateral vs. Central Counterparty Clearing in OTC Markets : Counterparty Exposures, Allocation Efficiency, and Applications

I construct a model of over-the-counter (OTC) trading to study equilibrium allocation properties under bilateral clearing (BC) and central counterparty (CCP) clearing of OTC derivatives. I show how CCP mutualizes individual counterparty exposures and prevents massive equilibrium defaults. I define allocation efficiency, show inefficient allocation under BC, and that CCP may improve efficiency. I also apply the model to produce different levels of equilibrium collateral requirement under CCP and to illustrate an aggregate risk-induced systemic CCP default