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their original capital contributions are insu- cient. us, a clearinghouse shares default or per- formance risk among its members.

bilateral trading relationships in OTC markets are not as subject to moral hazard problems because unlike in a clearinghouse, balance sheets are not public goods.

is sharing mechanism can increase the amount each trader receives on his derivative contract (Pir- rong, 2009). But like other sharing mechanisms, it can create incentive problems. In particular, like any sharing mechanism, it creates a moral hazard. Members of the clearinghouse have an incentive to take on too much risk because they realize that if this risk bankrupts them, other members of the clearinghouse will bear some of the loss.

Furthermore, participants in bilateral markets have private information about the performance risk of their counterparties and the risk charac- teristics of the products they trade. In addition, participants in bilateral transactions can vary the terms of trade, including collateral levels and con- tract prices, to reect the varying performance risk of dierent counterparties.

e clearinghouse can control this moral hazard by charging margins to its members to constrain their risk taking. However, collateral is costly, so it is costly to control moral hazard. Moreover, if clearinghouse members are heterogeneous—as is typically the case—it is impossible to choose a common collateral level that gives each mem- ber the appropriate incentive to control risk; the collateral level will underprice the risk of some members, who will trade too much, and overprice the risk of other members, leading them to trade too little.

Such information and exibility allows bilateral market participants to price performance risk more precisely than clearinghouses. e advan- tage of doing so is likely to be greatest for com- plex products14 traded by nancially complex rms (e.g., large banks).15 And indeed, it is gener- ally the case that more complex products traded by complex intermediaries are not cleared. us, again, there are very good economic reasons for clearing some products, and not clearing others. Mandating clearing will therefore impose costs on market users.

A clearinghouse also faces information asymme- tries that can lead to adverse selection problems. Member rms have better information about their creditworthiness, and possibly about the risks of the products they trade, than the clearinghouse. It is well known that adverse selection also gives rise to costs in any risk sharing arrangement.

In sum, although performance risk sharing through a clearinghouse has some advantages, it also has costs. Moreover, alternative arrange- ments, most notably bilateral trading, will be less costly under some circumstances. In particular,

Against this it is sometimes argued that clearing reduces systemic risks because it reduces dan- gerous interconnections in the nancial system. For instance, it is feared that the default of a large trader in the OTC market can cause the default of the traders this rm trades with, which in turn can cause the default of the traders these rms trade with, and so on. at is, contractual con- nections in OTC markets can spread default risks to many market participants.

It is peculiar indeed to justify clearing on these grounds, because clearing too spreads default

14

15

Here complexity does not necessarily relate to the complexity of contract terms. Instead, it relates to the complexity of the risk exposure of the contract. A highly standardized contract, such as a credit default swap, can give rise to very complex performance risks. See Pirrong (2009) for the details of this analysis.

E N E R G Y S E C U R I T Y I N I T I AT I V E

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