Regulating Clearing in Networks

Abstract: Recent regulations in the U.S. and Europe incentivize the use of central counterparty clearing houses (CCP) to clear derivatives, arguably to create a less complex and more transparent interbank network that is less prone to financial instabilities. We construct a network model with endogenous exposures and show that the core and the periphery react asymmetrically to these regulations. The core values opacity more and adopts clearing less. Consequently, bilaterally netted exposures to the core increase. The regulation also makes the CCP more exposed to the core than the periphery was pre-regulation. This endogenous network reaction to the regulation creates the unanticipated effect of reducing financial stability through more frequent coordination failures that start at the core and spread to the periphery and the CCP. A novel dataset on U.S. counterparty exposures, before and after the regulations, confirm the model’s testable implications.