Centralized Clearing for Over-the-Counter Derivatives

Systemic risk propagated through over-the-counter derivatives can best be managed by a public-private central counterparty clearing house (CCP). Though private CCPs provide an adequate amount of clearing's private good, they do not provide the socially optimal level of the public good or impure goods. By undersupplying both public and impure goods, private CCPs may exacerbate the conditions under which financial crises develop and propagate. A public-private partnership could align incentives so that the CCP produces the socially optimal level of the private, public, and impure goods. A partnership using a two-part pricing scheme for OTC structured composite transactions could properly compensate both partners and provide an effective policy instrument for controlling systemic risk. Moreover this structure, in contrast to current proposed government regulations, will not drive out the "good" with the "bad" OTC derivative instruments.