The Economic Drivers and Consequences of Client Clearing

Views and opinions expressed are those of the authors and do not necessarily represent official positions or policy of the Office of Financial Research (OFR) or U.S. Department of the Treasury.

Expanded central counterparty (CCP) clearing following the 2007–09 financial crisis represents a foundational shift in global financial markets. CCPs stand between the buyer and seller of cleared transactions to eliminate the risk that these two parties fail to meet their contractual obligations to one another. In doing so, they aim to enhance market transparency and stability. Dealers historically cleared more frequently than their nondealer clients such as hedge funds and mutual funds, but clients now account for the majority of the risk managed by CCPs.

In their working paper, “Clearing Markets and Client Clearing Services,” Salil Gadgil, OFR Researcher; Robin Lumsdaine, Professor of Finance at the Kogod School of Business at American University; and Mark Paddrik, OFR Acting Deputy Director of Research and Analysis; examine the economic drivers of client clearing and how it affects market structure and stability. To understand why clients adopt clearing and how doing so changes their interactions with dealer banks, the authors use confidential data on credit default swaps (CDS) from The Depository Trust & Clearing Corporation.

The authors find that central clearing facilitates the consolidation of offsetting contracts for dealers and is accordingly associated with more favorable pricing for clients. Clients that adopt clearing expand their dealer networks and reduce counterparty concentration, consistent with enhanced competition. Clients are dependent on dealers to access CCPs, however, which may limit their ability to clear when dealers experience stress.