Centralised clearing improves pricing and competition

The article, “Clearing Markets and Client Clearing Services”, is co-authored by Robin Lumsdaine, Professor of Applied Econometrics at Erasmus School of Economics, and Salil Gadgil and Mark Paddrik from the U.S. Department of the Treasury’s Office of Financial Research. The researchers analyse why institutional investors use central clearing and show that cleared transactions deliver better pricing for clients while improving dealers’ ability to manage risk. 

How central clearing functions 

Central clearing has become a cornerstone of financial markets since the global financial crisis. In a cleared transaction, a central counterparty (CCP) effectively steps in between buyer and seller, reducing the risk to each party that the other one fails to meet its obligations. A handful of large banks, also referred to as dealers in the paper, are direct members of CCPs. Clients, by contrast, are institutional investors who must rely on these dealer-members to clear trades. As Lumsdaine explains, central clearing functions ‘like a form of insurance,’ ensuring transactions can still be completed even if one party defaults. 

There is ongoing regulatory interest in clearing, both in the United States and Europe. The US is poised to mandate that all Treasury transactions be centrally cleared, while the European Commission continues to review the structure and accessibility of central clearing in the EU.  

The results of this study add new arguments to this discussion, by suggesting that while clearing broadly can improve pricing, competition, and risk management, there are important considerations regarding access and resilience, particularly in times of financial stress. As the paper concludes, facilitating client access to CCPs is ‘increasingly critical to preserving both the functioning and systemic resilience of financial markets’. 

A benefit for clients, not just for dealers 

While much of the literature has highlighted the benefits of clearing for dealers, this is one of the first studies to focus on how clearing affects clients specifically, and market functioning more generally. A central finding is that clearing benefits both sides of the market, but in different ways. For dealers, clearing allows the netting of offsetting positions, for example, balancing a buy position with one counterparty against a sell position with another. This reduces the amount of capital they must hold, thereby enabling them to put more capital to productive uses. For clients, the benefit appears in pricing: prices on cleared trades are, on average, more favourable than prices on comparable uncleared trades. As Lumsdaine notes, this indicates that ‘there is also a benefit from the client’s perspective’, not just for dealers. 

Second, the researchers show that when clients begin clearing, they expand the number of dealers they transact with and reduce concentration in their trading relationships. This suggests clearing lowers barriers to accessing different market participants and can promote greater competition. Lumsdaine notes that understanding client behaviour is crucial because ‘clients now account for the majority of the risk managed by CCPs.’ 

Access to clearing can be hindered during periods of stress 

At the same time, the research highlights potential vulnerabilities. When a clearing member faces difficulties, clients reliant on that member experience reduced access to clearing. Following the collapse of Archegos and the resulting distress of Credit Suisse, clients that relied heavily on the latter institution saw a sharp reduction in their ability to clear trades. This shows that, despite making markets safer overall, access to clearing can deteriorate precisely when markets are under pressure. 

To study these questions, the authors use confidential transaction-level data on U.S. credit default swaps from the Depository Trust & Clearing Corporation. This allows the authors to directly link individual transactions to clearing decisions, something that has not been possible in earlier research. They combine statistical analysis of pricing, risk, and trading relationships with a case study of the Credit Suisse episode. 

The health and stability of our financial infrastructure 

The findings have implications for market participants. Dealers can better understand how offering clearing services strengthens client relationships and helps retain or even expand market share. Institutional clients can use the results to assess when clearing provides pricing benefits and how relying on a single clearing member increases vulnerability during periods of stress. Regulators may draw on the evidence when considering future clearing mandates and how to facilitate safe and broad access to CCPs. 

For citizens, the relevance lies in financial stability. While few individuals engage directly with derivatives markets, the infrastructure that supports them underpins the broader economy. As Lumsdaine puts it, ‘everybody should be concerned about the health and stability of our financial infrastructure’.