Journal of Economic Behavior & Organization 83 (2012) 609–626 Contents lists available at SciVerse ScienceDirect Journal of Economic Behavior & Organization j ourna l ho me pag e: www.elsevier.com/locate/j ebo Clearing networks , Marco Galbiati a,b,∗ , Kimmo Soramäki c a Bank of England, United Kingdom b ECB, Germany c Aalto University School of Science and Technology, Helsinki, Finland a r t i c l e i n f o Available online 26 June 2012 JEL classification: E58 G01 G18 Keywords: Central counterparty CCP Clearing Settlement Network analysis a b s t r a c t In several financial markets, counterparty risk is reallocated away from traders via ‘nova- tion’, a step of the clearing process. By novation, a third party steps into a bilateral contract, guaranteeing performance of both legs of the trade. Central counterparties (CCPs) are entities whose special purpose is novating trades, relieving market participants from coun- terparty risk. However, in most cases, the CCP is not the sole novator: the CCP novates contracts between its clearing members, which in turn novate trades for other (typically smaller) participants and so on. This paper develops an abstract model of such hierarchical clearing networks. Novation is modelled here as a function which transforms (trading) exposures into (cleared) exposures. By using Monte Carlo simulations, we study how such function is affected by the clearing network’s topology, drawing conclusions on the risks faced by the CCP, and on the system’s margin requirements. Crown Copyright © 2012 Published by Elsevier B.V. All rights reserved. 1. Introduction The recent financial crisis prompted the notion that important parts of the financial infrastructure may need reforms. Not because the infrastructures experienced failures (on the contrary, they held up remarkably well during the turmoil), but because different or new infrastructures could have mitigated some of the problems which fuelled the crisis, among which were lack of information and lack of trust (Haldane, 2009). A main reason why well-designed financial infrastructures can be socially beneficial is that they can allow a better allocation of risks. Market participants typically seek market risk in the form of profit opportunities. Instead, counterparty risk is most often considered an unwanted feature of a market, a friction that participants are unwilling, and sometimes unprepared, to manage. 1 Indeed, during the crisis several key markets (e.g. money markets) ceased to function precisely due counterparty risk, threatening the viability of the whole system.  The views expressed in this paper are those of the authors, and not necessarily those of the BoE nor ECB.  Most of the practical knowledge about CCPs behind this paper comes from Matthew Dive, who patiently took us through the infinite intricacies of clearing. We also thank Simon Debbage, Claire Halsall, Matthew Vital, Anne Wetherilt for suggestions. We owe interesting discussion and comments to Charles Kahn, Richard Sowers, Katzeteru Tao and to participants to the 7th Bank of Finland simulation Seminar (Helsinki, August 2009). The views expressed here are those of the authors; they do not necessarily reflect the views of their parent institutions. Kimmo Soramäki gratefully acknowledges a grant from Säästöpankkien TutkimussäätiBank. ∗ Corresponding author at: Bank of England, United Kingdom. E-mail address: Marco.Galbiati@ecb.int (M. Galbiati). 1 A possible reason for this is that counterparty risk is more difficult to measure and control, as the events associated with it are more sudden and ‘lumpier’. 0167-2681/$ – see front matter. Crown Copyright © 2012 Published by Elsevier B.V. All rights reserved. http://dx.doi.org/10.1016/j.jebo.2012.05.013