Clearing networks

In several financial markets, counterparty risk is reallocated away from traders via ‘novation’, 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 counterparty 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.