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Counterparty Credit Risk: The new challenge for global financial markets by Jon Gregory

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Chapter 14

The Role of a Central Counterparty

“It is dangerous to be right when the government is wrong.”

Voltaire (1694–1778)

In this chapter we consider the role of large central counterpartie s to provide a means for centralisation, mutualisation and reduction of counterparty risk. Following the credit crisis that started in 2007, there has been a significant interest in having centralised clearing entities for counterparty risk. In particular, the interest has been strong for credit derivatives products with their embedded wrong-way risks. We will discuss in detail the viability of reducing counterparty risk in the OTC derivatives market by using a central counterparty.

14.1 CENTRALISED CLEARING

The dramatic increase in counterparty risk due to the credit crisis and the realisation that no counterparty was immune to severe financia l distress brought many calls for a solution to the global counterparty risk problem. Having a centralised clearing counterparty provides a potential solution to the problem of counterparty risk clogging up markets, especially those such as credit derivatives. Many operators of trading facilities, such as exchanges, are struggling to innovate in financial markets and cover new instruments without a partner clearing facility.

14.1.1 Background

Market risk can be eliminated by entering into an offsetting contract. However, unless this is done with the same counterparty as the original position(s), then additional counterparty risk will be generated. ...

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