2013-11: Centralized Clearing for Over-the-Counter Derivatives

Systemic risk propagated through over-the-counter (OTC) 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. We propose using an RFQ platform with an active transaction permissioning system that uses position risk based on Monte Carlo simulation to estimate default risk and a two-part pricing scheme to efficiently price the risk retained by the clearing function. This structure, in contrast to current proposed government regulations, would price the clearing risk of OTC derivative instruments according to their financial risk rather than according to a qualitative classification of "good" versus "bad" contracts.