Do central counterparties reduce counterparty and liquidity risk? Empirical results

Carlos León*, Ricardo Mariño, Carlos Cadena

*Corresponding author for this work

Research output: Contribution to journalArticleScientificpeer-review

Abstract

A central counterparty (CCP) interposes itself between buyers and sellers of financial contracts to extinguish their bilateral exposures. Therefore, central clearing and settlement through a CCP should affect how financial institutions engage in financial markets. Though, financial institutions' interactions are difficult to observe and analyze. Based on a unique transaction dataset corresponding to the Colombian peso non-delivery forward market, this article compares - for the first time - networks of transactions agreed to be cleared and settled by the CCP with those to be cleared and settled bilaterally. Networks to be centrally cleared and settled show significantly higher connectivity and lower distances among financial institutions. This suggests that agreeing on central clearing and settlement reduces liquidity risk. After CCP interposition, exposure networks show significantly lower connectivity and higher distances, consistent with a reduction of counterparty risk. Consequently, evidence shows CCPs induce a change of behavior in financial institutions that emerges as two distinctive economic structures for the same market, which corresponds to CCP's intended reduction of liquidity and counterparty risks.
Original languageEnglish
Pages (from-to)25-34
JournalAlgorithmic Finance
Volume9
Issue number1-2
DOIs
Publication statusPublished - 2021
Externally publishedYes

Keywords

  • central clearing
  • central counterparty
  • Counterparty risk
  • liquidity risk
  • networks

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