Centralized clearing for over‐the‐counter derivatives

Purpose – Systemic risk propagated through over‐the‐counter (OTC) derivatives can best be managed by a public‐private central counterparty clearing house. The purpose of this paper is to outline the market microstructure necessary for such a clearing house. Design/methodology/approach – The paper proposes using an request for quote platform with an active permissioning system that uses analytic approximations based on Monte Carlo simulation to estimate default risk and a two‐part pricing scheme to efficiently price that risk. Findings – It is found that comprehensive clearing for complex and standardized derivatives is feasible using the clearing framework. Research limitations/implications – This research is limited by the authors' ability to give empirical examples. The paper gives a short example with data, but given the constraints on length, cannot go into more detail. Practical implications – This comprehensive clearing structure, in contrast to current proposed government regulations, will not drive out the “good” with the “bad” OTC derivative instruments. Originality/value – This is the only paper the authors are aware of that outlines a detailed framework for clearing all OTC derivatives.