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Board of Governors of the Federal Reserve System (US)
Finance and Economics Discussion Series
Transparency and Collateral: The Design of CCPs' Loss Allocation Rules
Gaetano Antinolfi
Francesca Carapella
Francesco Carli
Abstract

This paper adopts a mechanism design approach to study optimal clearing arrangements for bilateral financial contracts in which an assessment of counterparty risk is crucial for efficiency. The economy is populated by two types of agents: a borrower and lender. The borrower is subject to limited commitment and holds private information about the severity of such lack of commitment. The lender can acquire information at a cost about the commitment of the borrower, which affects the assessment of counterparty risk. When truthful revelation by the borrower is not incentive compatible, the mechanism designer optimally trades off the value of information about the lack of commitment of the borrower with the cost of incentivizing the lender to acquire such information. Central clearing of these financial contracts through a central counterparty (CCP) allows lenders to mutualize their counterparty risks, but this insurance may weaken incentives to acquire and reveal informatio n about such risks. If information acquisition is incentive compatible, then lenders choose central clearing. If it is not, they may prefer bilateral clearing to prevent strategic default by borrowers and to economize on costly collateral. Central clearing is analyzed under different institutional features observed in financial markets, which place different restrictions on the contract space in the mechanism design problem. The interaction between the costly information acquisition and the limited commitment friction differs significantly in each clearing arrangement and in each set of restrictions. This results in novel lessons about the desirability of central versus bilateral clearing depending on traders' characteristics and the institutional features defining the operation of the CCP.


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Gaetano Antinolfi & Francesca Carapella & Francesco Carli, Transparency and Collateral: The Design of CCPs' Loss Allocation Rules, Board of Governors of the Federal Reserve System (US), Finance and Economics Discussion Series 2019-058, Aug 2019.
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Keywords: Limited commitment ; Central counterparties ; Collateral
DOI: 10.17016/FEDS.2019.058
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