Centralized clearing for over‐the‐counter derivatives

Systemic risk propagated through over‐the‐counter (OTC) derivatives can best be managed by a public‐private central counterparty clearing house. The purpose of this paper is to outline the market microstructure necessary for such a clearing house.

The paper proposes using an request for quote platform with an active permissioning system that uses analytic approximations based on Monte Carlo simulation to estimate default risk and a two‐part pricing scheme to efficiently price that risk.

It is found that comprehensive clearing for complex and standardized derivatives is feasible using the clearing framework.

This research is limited by the authors' ability to give empirical examples. The paper gives a short example with data, but given the constraints on length, cannot go into more detail.

This comprehensive clearing structure, in contrast to current proposed government regulations, will not drive out the “good” with the “bad” OTC derivative instruments.

This is the only paper the authors are aware of that outlines a detailed framework for clearing all OTC derivatives.