Central Counterparty Clearing and Systemic Risk Insurance in OTC Derivatives Markets

How can Central Counterparty (CCP) clearing help to make the over-the-counter (OTC) derivatives market safer? To answer this question, we lay out two views of risk management. The “contract view” considers how to control the loss given default, while the “counterparty view” looks at the likelihood of a default first and, hence, at the incentives to take on risks. Applying the latter view to the market for OTC derivatives, we argue that the risk transfer that characterizes CCP clearing leads to incentives for individual risk-taking, as well as a collective failure of participants to take into account that the OTC derivatives market concentrates aggregate, system-wide risk. With central clearing this systemic risk externality worsens, as CCPs concentrate this risk further and become too-big-to-fail. To correct this problem, we propose the establishment of systemic risk insurance as a necessary component of CCP clearing in OTC derivatives markets. ∗A French version of this article has been published in the Revue d’Economie Financiere.