Wednesday, 4 June 2008

Are central counterparties a good idea?

Yes, and here's why. (This example is taken from a paper by Markus Brunnermeier.) Suppose we have a circle of identical interest rate swaps: A <-> B <-> C <-> D and back to A. All parties are fully market risk hedged. B wants to reduce its counterparty risk so it offers to assign A its swap with C. A refuses because it is troubled by C's credit quality. Therefore B has to continue to put up capital to support its exposure to both A and C.

With a central counterparty P however, everyone would face P and these issues would not arise.

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