Abstract

Co-authors: Allen Cheng (Johns Hopkins University), Sriram Rajan (Office of Financial Research)

We quantify the level of market concentration in a financial system where dealers hedge their operations by trading through a Central Counterparty (CCP). We partition individual dealer total assets into hedging and operating portfolios and model interactions of clearing entities with the CCP using Wright-Fisher diffusion dynamics.

We derive the unique Nash equilibrium attained when each dealer optimizes its hedge ratio. More specifically, we identify a relationship between the effectiveness of the clearing member’s hedging portfolio transacted over the CCP and the volatility it experiences. As a consequence of this outcome and under optimal hedging, we show that market concentration tends to increase over time hence presenting systemic risk. We propose a self-financing tax and subsidy system that can effectively control market concentration. Using the margin model of Duffie, Scheicher and Vuillemey (2014), we calibrate our framework via an extensive dataset consisting of CDS bilateral exposures cleared through a US-based CCP . We analyze the calibrated model parameters and discuss implications for policy makers.