The Value of Central Clearing

• Author: GUILLAUME VUILLEMEY
• DOI: http://doi.org/10.1111/jofi.12902
• Published date: 01 August 2020
• Date: 01 August 2020

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 4 •AUGUST 2020

The Value of Central Clearing

GUILLAUME VUILLEMEY∗

ABSTRACT

I study a contracting innovation that suddenly insulated traders of hedging contracts

against counterparty risk: central clearing counterparties (CCPs) for derivatives. The

first CCP was created in Le Havre (France) in 1882, in the coffee futures market.

Using triple difference-in-differences estimation, I show that central clearing changed

the geography of trade flows Europe-wide, to the benefit of Le Havre. Inspecting

the mechanism using trader-level data, I find that the CCP solved both a “missing

market” problem and adverse selection issues. Central clearing also facilitated entry

of new traders in the market. The successful contracting innovation quickly spread

to other exchanges.

FINANCIAL FRICTIONS CAN PREVENT GAINS from trade from being realized and thus

resources from being efficiently allocated. However, whether financial frictions

impair trade is not exogenous: agents can design contracts to mitigate or undo

their effects (Allen and Gale (1988)). Throughout history, a number of contract-

ing innovations—from the bill of exchange to limited liability—improved cap-

ital allocation and risk-sharing, thus contributing to long-term growth (North

(1991)). Yet empirically identifying the causal impact of contracting innova-

tions on resource allocation is challenging. In particular, it is often difficult to

precisely date the appearance of contracting forms that are now widespread in

financial markets, and data to study these events are often lacking.

In this paper, I study a contracting innovation that has become essential in

present-day financial markets, namely, central clearing counterparties (CCPs)

for derivatives. As an experiment, I use the creation of the Caisse de Liquida-

tion des Affaires en Marchandises (CLAM) in the market for coffee futures in

Le Havre (France) in 1882. The contracting innovation brought about by the

∗Guillaume Vuillemey is at HEC Paris and CEPR. I am grateful to the editor (Philip Bond);

an associate editor; an anonymous referee; Patrice Baubeau; Bruno Biais; Jean-Edouard Col-

liard; Laura Rischbieter; seminar participants at University of Melbourne, Cleveland Fed, Ohio

State University, University of Rochester, Arizona State University, University of Amsterdam,

HEC Paris, and Paris School of Economics; and conference participants at the 4 Nations’ Cup

(ESMT), FIRS 2019, EFA 2019, and ACPR Workshopfor comments. I thank the Chair ACPR/Risk

Foundation: Regulation and Systemic Risk, Investissements d’Avenir (ANR-11-IDEX-0003/Labex

Ecodec/ANR-11-LABX-0047), and ANR (FIRR) for supporting this work. I have read The Journal

of Finance disclosure policy and have no conflicts of interest to disclose.

Correspondence: Guillaume Vuillemey, Department of Finance, HEC Paris, 1 Rue de la

Lib´

eration, Jouy-en-Josas 78351, France; e-mail: vuillemey@hec.fr.

DOI: 10.1111/jofi.12902

C2020 the American Finance Association

2021

2022 The Journal of Finance R

CLAM is to fully insulate futures traders against counterparty risk. Specifi-

cally, for the first time, a clearing institution interposed itself between traders,

becoming a buyer to any seller and a seller to any buyer, so as to guarantee

the execution of contracts. Before 1882, earlier clearinghouses, for example, in

Liverpool or New York, only offered netting services to facilitate the settlement

of transactions. The contracting arrangement invented by coffee traders in Le

Havre quickly spread worldwide and, after the 2008 financial crisis, central

clearing became mandatory globally for standardized derivatives.

I hand-collect rich archive data and conduct empirical analysis that yields

two contributions. The first is to show that greater risk-sharing opportunities

with derivatives had a significant causal impact on trade flows in underlying

commodities. The creation of the CLAM arguably satisfies exogeneity require-

ments, as it did not follow any pre-trend in trade flows in Le Havre, and it

was heavily debated by traders who did not foresee its impact on trade flows.

For identification, I estimate a triple difference-in-differences model. The three

sources of variation in trade flows that I exploit are (i) before and after 1882,

(ii) between Le Havre and other European markets where clearing is not in-

troduced and, (iii) within Le Havre, between coffee and other commodities that

remain uncleared. The specification enables many confounding factors, such

as commodity-specific and harbor-specific demand and supply shocks, to be

ruled out.

The estimation results show a positive and significant effect of the introduc-

tion of central clearing on coffee trade flows in Le Havre. I first estimate the

triple difference-in-differences model within France, comparing trade flows in

Le Havre with 22 other harbors. I find that the share of coffee imports enter-

ing France in Le Havre increased by 11.1 percentage points relative to control

commodities. I address residual endogeneity concerns by replicating the esti-

mation with cotton trade flows. Although the CLAM was created to mitigate

counterparty risk on coffee futures, it also accepted clearing of cotton futures.

In this case, the creation of the CLAM was exogenous to conditions in the cotton

market. Yet the results continue to hold when focusing on cotton trade flows,

using other textiles as a control.

Next, I extend my analysis to the European scale, reconstructing trade flows

in cleared and control commodities for seven countries. I show that central

clearing changed the geography of trade flows Europe-wide: after 1882, a sig-

nificantly larger share of coffee entered Europe in Le Havre, was warehoused

there, and eventually reexported to neighboring countries. The share of coffee

imports from France by the sample countries increased by 2.9 to 7.3 percentage

points, relative to control commodities. I also provide suggestive evidence that

larger inventories of coffee in Le Havre helped smoothing coffee consumption

in France. Finally, I support the quantitative results above with narrative evi-

dence. Many contemporaries wrote that the CLAM boosted trade in Le Havre

and, within 10 years, nine other European futures exchanges had introduced

CCPs. Therefore, the contracting innovation spread quickly. The focus on trade

flows distinguishes the paper from earlier work by Bernstein, Hughson, and

The Value of Central Clearing 2023

Weidenmier (2019), who study the impact of clearing on the pricing of counter-

party risk.

As a second contribution, I pin down the mechanism through which cen-

tral clearing affected trade flows. The main claim is that central clearing in-

creased the ability of coffee dealers to hedge their inventories. This in turn

induced them to import more coffee, warehouse it until it is demanded for

consumption, and re-export it. For this mechanism to explain the findings,

several requirements must be met. Most importantly, it must be the case that

hedging markets dysfunction before central clearing, and restart afterward.

Consistent with this idea, I show that central clearing was introduced fol-

lowing a global crisis in coffee markets in 1880, during which counterparty

risk impaired hedging possibilities. I then show that the CLAM was explicitly

designed to mitigate counterparty risk, with high equity, high margin require-

ments, and a chairman of the board with a strong reputation for honesty. A

last requirement for the improvement in hedging technology to explain the re-

sults is that traders make use of the CCP. Remarkably, even though use of the

CLAM was costly and not mandatory,an overwhelming majority of traders were

using it.

I then distinguish between two channels through which hedging possibili-

ties could increase. A first possibility is that, before central clearing, traders

were willing to hedge against the default risk of their counterparties, but in-

struments to do so were missing. Under this argument, the CCP solved the

“missing market” problem and thus made derivatives better hedging instru-

ments. To test for this channel, I study changes in the composition of the pool

of established traders around the introduction of the CLAM, using trader-level

data on coffee transactions. If the main friction before central clearing is the

existence of a missing market, then trading should concentrate among traders

with a low observable probability of default. Consistent with this idea, I find

that the share of low-quality traders, defined as traders exiting the market

within the next two years, was low before the CLAM (8.2%). Furthermore, it

did not increase with its creation, while trading volume in futures increased

massively (by 303% within six months). Thus, for established traders, a missing

market problem was preventing hedging ex ante.

A second possibility is that central clearing mitigated an adverse selection

problem: before the CLAM was in place, traders were unable to distinguish

between high- and low-quality counterparties, which impaired futures trad-

ing. I provide several pieces of evidence consistent with adverse selection being

significant for a subset of traders. To begin, there is evidence that the system

that prevailed before central clearing, under which futures trading was un-

collateralized and based on reputation, dysfunctioned during the 1880 crisis:

it became harder to distinguish between high- and low-quality traders based

solely on reputation. Traders designed a CCP to separate trader types by re-

quiring costly collateral to be posted. In this context, central clearing was the

most cost-efficient mechanism to require collateral, due to its netting bene-

fits. Additionally, I provide econometric evidence that adverse selection was