Are We Building the Foundations for the next Crisis Already? the Case of Central Clearing

Counterparty risk has been at the heart of the recent crisis driven by the toxicity of over-the-counter (OTC) derivatives and failure of high profile financial institutions. This has led policymakers to propose laws that would require most standard OTC derivatives to be centrally cleared. Central clearing involves a central counterparty (CCP) intermediating a transaction and acting as an insurer of counterparty risk. This has advantages, potentially leading to enhanced transparency and liquidity in markets and smoothing major systemic problems. The idea is also popular since it represents a single and intuitively simple solution to the severe problem of counterparty risk. However, whilst CCPs may have a role to play in reducing counterparty risk, they can also be counterproductive to the stability of financial markets. In this paper, we argue that the introduction of CCPs should be carefully considered and that, far from reducing counterparty risk, they may actually allow it to breed and contribute to the next crisis.