Counterparty Risk Externality: Centralized Versus Over-the-Counter Markets

50 Pages Posted: 21 Mar 2011

See all articles by Alberto Bisin

Alberto Bisin

New York University (NYU) - Department of Economics; New York University (NYU) - Center for Experimental Social Science (CESS); National Bureau of Economic Research (NBER)

Viral V. Acharya

New York University (NYU) - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); National Bureau of Economic Research (NBER)

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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

Bisin, Alberto and Acharya, Viral V. and Acharya, Viral V., Counterparty Risk Externality: Centralized Versus Over-the-Counter Markets (March 16, 2011). Available at SSRN: https://ssrn.com/abstract=1788187 or http://dx.doi.org/10.2139/ssrn.1788187

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