The Effects of Imposing a Central Counterparty in a Network

A recent regulatory change involves the use of clearing in financial transactions. Under the new Dodd-Frank mandatory clearing regime, the ultimate counterparty of several transactions (swaps, futures, derivatives, etc) will no longer be the entity at the other side of the transaction. Instead the transaction will be submitted to a Central Clearinghouse (CCP) for clearing. Once cleared, the Clearinghouse is the counterparty to all trades, and the regulatory bodies (CFTC and SEC) will impose constraints that mitigate risks. Similar steps have been recently followed by the European Union’s new regulations. The rationale of forcing the use of CCPs is to reduce counterparty risk and to mitigate network effects. What is the effect of these impositions on the way banks interact with each other? Why banks were not exploiting clearing in absence of regulations? We construct a model to understand how the network may change with and without clearinghouses and how those changes can translate in a stronger potential for contagion and endogenously higher financial fragility, and also what is its impact on the efficiency of the banking sector.