Failure and Rescue in Central Clearing Counterparty Design

After the financial crisis, a financial innovation, the central clearing counterparty (CCP) has been proposed and proved its importance in facilitating the clearing of interbank liabilities. In its original design, there is a possibility that the CCP may go default, and thus jeopardizing the stability of the financial system. In order to address this issue, we propose a New Central Clearing Counterparty (NCCP) design. In our model, banks with positive cash balance are always able to stop the fire sales and help the troubled banks in the system. The rescue process leads to benefits for all banks in the long run and many banks also have incentives to do so even from the perspective of short term benefits. We measure the effects of default from both the default loss and the liquidation loss. The liquidation loss not only affects the banks who are going to do the fire sale, but also leads to a decrease on the net worth of solvent banks. An empirical study based on the Bankscope data set is carried out to illustrate the advantages of the new design in harnessing the systemic risk