Endogenous Derivative Networks

42 Pages Posted: 29 Apr 2014

See all articles by Guillaume Vuillemey

Guillaume Vuillemey

HEC Paris - Finance Department

Regis Breton

Banque de France

Date Written: April 2014

Abstract

This paper proposes a network formation model of an OTC derivatives market where both prices and quantities are bilaterally negotiated. The key feature of the framework is to endogenize the network of exposures, the gross and net notional amounts traded and the collateral delivered through initial and variation margins, as a function of idiosyncratic counterparty risk and regulatory collateral and clearing requirements. Using the framework, we investigate numerically the size of the derivatives network, the aggregate collateral demand and the pricing of the contracts under the following schemes: (i) various levels of collateralization for uncleared transactions, (ii) rehypothecation of received collateral and (iii) clearing through a central clearing party (CCP). Overall results suggest that dynamic effects due to the endogeneity of the derivative network to the collateralization and clearing requirements have sizeable consequences on both contract volumes and prices. Intermediary trading and market liquidity are reduced by higher collateralization requirements and enhanced by rehypothecation, while the potential for contagion is reduced. Not accounting for dynamic effects in current market conditions may lead to over-estimate collateral demand induced by mandatory central clearing by up to 22%.

Keywords: Collateral, Credit derivatives, Central Clearing Party (CCP), Rehypothecation, Network formation

JEL Classification: G11, G17, G28

Suggested Citation

Vuillemey, Guillaume and Breton, Regis, Endogenous Derivative Networks (April 2014). Banque de France Working Paper No. 483, Available at SSRN: https://ssrn.com/abstract=2430639 or http://dx.doi.org/10.2139/ssrn.2430639

Guillaume Vuillemey (Contact Author)

HEC Paris - Finance Department ( email )

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Paris, Not Applicable 78351
France
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HOME PAGE: http://sites.google.com/site/guillaumevuillemey/home

Regis Breton

Banque de France ( email )

Paris
France

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