One of the important current developments in financial markets is mandatory central clearing of OTC derivatives. This new legislation (Dodd-Frank act in the US, EMIR in Europe) is meant to reduce counterparty risk in derivatives transactions, by introducing a central clearing counterparty (CCP) between buyers and sellers of derivatives. Such a clearing counterparty should in theory remove credit risk that individual firms face and act as a cushion in the event of market stress. However, this also leads to a great systemic importance of CCPs within the financial system.
In this talk, we will discuss the effects of central clearing of OTC derivatives on the financial system. We will analyze these effects by means of simulations of hypothetical (but realistic) financial systems and compare stability and default characteristics of systems with and without CCPs.
Furthermore, we address the feasibility and practicalities of such a study for real financial systems, such as that in The Netherlands and Europe as a whole. We discuss the configuration of a financial system in terms of derivatives transactions and ways to model this (often opaque and unknown) configuration by means of a realistic network. We address the data issues and, particularly, ingenious ways of dealing with the lack of transparency and of data.
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