The Demand for Central Clearing: To Clear or Not to Clear, That is the Question

Abstract

This paper is a first attempt at empirically analyzing whether post-crisis regulatory reforms developed by global-standard-setting bodies have created appropriate incentives to centrally clear Over-The-Counter (OTC) derivative contracts. We analyze three main drivers of the decision to clear: 1) the credit risk of the counterparty; 2) the characteristics of the contract; 3) the clearing member’s net exposure vis-a-vis the Central Counterparty Clearing House (CCP). We use confidential European trade repository data on single-name sovereign Credit Derivative Swap (CDS) transactions, and show that both the seller and the buyer manage counterparty’s exposures and capital costs, strategically choosing to clear when the counterparty is riskier. The riskiness of the underlying reference entity also enters the decision to clear as it affects both Counterparty Credit Risk (CCR) capital charges for OTC contracts and CCP margins for cleared contracts. We empirically investigate the trade-off between the two and find that the likelihood to clear is higher if the reference entity becomes more risky, but only for the riskier sovereign CDS in the sample, while for safer sovereign CDS the opposite is true. Our findings suggest that CCP margin savings considerations may be the main force behind the decision to clear for safer instruments while CCR exposures and capital charges may prevail for riskier ones. Lastly, we find some evidence that when the transaction helps reducing counterparty’s overall outstanding positions (and therefore margins) vis-a-vis the CCP, the likelihood to clear is higher. This result holds true as long as considerations such as CCR counterparty risk and wrong-way risk do not prevail.