Centralized netting in financial networks

Abstract

We consider how the introduction of centralized netting in financial networks affects total netted exposures between counterparties. In some cases there is a trade-off: centralized netting increases the expectation of net exposures, but reduces the variance. We show that the set of networks for which expected net exposures decreases is a strict subset of those for which the variance decreases, so the trade-off can only be in one direction. For some network structures, introducing centralized netting is never beneficial to dealers unless sufficient weight is placed on reductions in variance.This may explain why, in the absence of regulation, traders in a derivatives network do not develop central clearing. Our results can be used to estimate margin requirements and counterparty risk in financial networks.

Five Fundamental Questions on Central Counterparties

“…13 I am following the same notation convention in this strand of the CCP literature starting with the seminal article by Duffie and Zhu (2011) followed by Cont and Kokholm (2014); Garratt and Zimmerman (2017) and Hwang and Kim (2020).…”

“…The next contribution in the first approach (Garratt and Zimmerman, 2017) looks at exposures from a network perspective as in reality the assumptions of a homogeneous network do not hold. Lewandowska and Mai (2018) show, based on actual data from three large CCPs, that the distribution of clearing members is indeed heterogeneous, resembling an exponential distribution.…”

The Cost of Clearing Fragmentation

“…He uses this extended framework to identify crowding in clearing member positions as an "overlooked" risk for CCPs. Garratt and Zimmerman (2018) Our paper also contributes to the literature on dynamic inventory management.…”

Bilateral Netting and Systemic Liquidity Shortages in Banking Networks

“…4 Allen and Gale (2000), Battiston et al (2012), Elliott et al (2014), Acemoglu et al (2015). 5 We use this expression to distinguish our topic from the much more explored issues of netting interbank off-balance-sheet exposures associated to OTC derivatives on the one hand (Bliss and Kaufman, 2006;Cont and Kokholm, 2014;Garratt and Zimmerman, 2017), and netting settlement agreements in payment systems on the other one (Angelini et al, 1996;Freixas and Parigi, 1998)).…”