Systemic Risk in Central Clearing : Should Crowded Trades Be Avoided?

If all intermediaries enter the same market-making “bet” on the same side, fast-moving capital gets tied up in a crowded trade. This creates systemic risk for a central clearing party (CCP) since multiple traders might default when the bet turns extremely sour. The CCP then has to unwind the inherited portfolios in a market with little fast-moving capital and potentially pays a fire sale premium. Equilibrium analysis reveals that crowded trades are socially costly when some liquidity demand is left unserved. The other extreme, perfect diversity, maximizes the fire sale premium. Some crowding may thus be socially optimal