Central Counterparty Clearing: Incentives, Market Discipline and the Cost of Collateral

This paper analyzes central counterparty (CCP) clearing { dened as the diversication of default risk through novation { in the presence of moral hazard that aggravates counterparty risk. Collateral is costly and serves two purposes: it insures against default and provides incentives to avoid moral hazard. When counterparty risk is not directly observable, I show that central clearing can lead to higher collateral requirements for two dierent reasons. First, a CCP oering diversication of risk cannot selectively forgo incentives for transactions that optimally use collateral only for insurance. Second, requiring more collateral for better incentives can reduce market liquidity and adversely aect market discipline which is a substitute for collateral. Hence, while CCP clearing can lower default through higher collateral requirements,