The Emergence and Future of Central Counterparties

We study the role of a central counterparty (CCP) in controlling counterparty risk. When trading is organized via a centralized exchange with fungible contracts -- as in a futures market -- we show that it is optimal to clear trades via a CCP that uses (i) novation to pool the risk of default and (ii) mutualization of losses to insure against the aggregate cost of default in the form of price risk. We then analyze the design of CCP clearing for over-the-counter (OTC) trades where contracts are customized and, hence, not fungible. A CCP can still offer gains from novation by pooling default risk across all customized contracts. Bargaining in OTC trades leads to an inefficient allocation of default risk across trades. A transfer scheme can alleviate this inefficiency, but necessitates novation being offered by a CCP. Hence, the benefit from CCP clearing for OTC markets goes beyond simple netting as it is a prerequisite for an efficient allocation of default risk in such markets.