In a network of connected financial institutions (FIs), pairs of FIs
hedge portfolio risks using over-the-counter contracts, becoming exposed
to counterparty risk. Defaults within pairs can propagate through
the network. With central clearing, collateral is fungible across
pairs, allowing high protection at low collateral costs, provided
that enough pairs choose to clear. FIs' choices determine collateral
requirements by central counterparties as well as contagion risk,
feeding back on each pair's incentive to...