Counterparty Risk Externality: Centralized Versus Over-the-Counter Markets
50 Pages Posted: 21 Mar 2011
There are 3 versions of this paper
Counterparty Risk Externality: Centralized Versus Over-The-Counter Markets
Counterparty Risk Externality: Centralized Versus Over-the-Counter Markets
Counterparty Risk Externality: Centralized Versus Over-the-Counter Markets
Date Written: March 16, 2011
Abstract
We model the opacity of over-the-counter (OTC) markets in a setup where agents share risks, but have incentives to default and their financial positions are not mutually observable. We show that there is "excess leverage" in that parties take on short OTC positions that lead to levels of default risk that are higher than Pareto-efficient ones. In particular, OTC markets feature a counterparty risk externality that we show can lead to ex-ante productive inefficiency. This externality is absent when trading is organized via a centralized clearing mechanism that provides transparency of trade positions, or a centralized counterparty (such as an exchange) that observes all trades and sets prices. While collateral requirements can ameliorate the counterparty risk externality, they are in general inadequate in addressing it fully.
Keywords: OTC markets, leverage, counterparty risk, externality, transparency, centralized clearing, exchange, collateral, margin
JEL Classification: G14, G2, G33, D52, D53, D62
Suggested Citation: Suggested Citation
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