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The Design of a Central Counterparty

Published online by Cambridge University Press:  14 February 2023

John Chi-Fong Kuong  and
Vincent Maurin Open the ORCID record for Vincent Maurin [Opens in a new window]
John Chi-Fong Kuong
Affiliation:
Department of Finance of INSEAD john.kuong@insead.edu
Vincent Maurin*
Affiliation:
Department of Finance of the Stockholm School of Economics, Swedish House of Finance
*
vincent.maurin@hhs.se (corresponding author)
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Abstract

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This article analyzes the optimal allocation of losses via a Central Clearing Counterparty (CCP) in the presence of counterparty risk. A CCP can hedge this risk by mutualizing losses among its members. This protection, however, weakens members’ incentives to manage counterparty risk. Delegating members’ risk monitoring to the CCP alleviates this tension in large markets. To discipline the CCP at minimum cost, members offer the CCP a junior tranche and demand capital contribution. Our results endogenize key layers of the default waterfall and deliver novel predictions on its composition, collateral requirements, and CCP ownership structure.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 59 , Issue 3 , May 2024 , pp. 1257 - 1299
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.
Copyright
© The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank an anonymous referee, Jean-Edouard Colliard, Thierry Foucault (the editor), Thomas Gherig, David Murphy, Thomas Poulsen, Roberto Ricco, Anatoli Segura, Chester Spatt, Ernst-Ludwig von Thadden, Guillaume Vuillemey, Yan Xiong, Kostas Zachariadis, Haoxiang Zhu, and seminar and conference participants at 2022 BI Oslo, 2020 CMU Tepper, 2020 ICEF HSE, INSEAD, 2020 Stockholm School of Economics, 2021 UC3M, 2021 HKIMR, 2021 Vienna, the 2020 Asia-Pacific Corporate Finance Online Workshop, the 2021 Australasian Finance and Banking Conference, the 2022 CICF, the 2022 FT Webinar, the 2020 Gerzensee Workshop on Money, Payments, Banking and Finance, the 2020 Kelley Junior Finance Conference, the 2021 Microstructure Exchange, the 2021 NFN Young Scholars Webinar Series, 2021 OxFIT, the 2021 Paris December Finance Meeting, the 2021 SEC CFMR Conference, the 2021 SGF Conference, and the 2021 Stern Salomon Microstructure Conference for useful comments. Kuong acknowledges the financial support from INSEAD and HKIMR. Maurin thanks the Swedish House of Finance for financial support.

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