Counterparty risk externality: Centralized versus over-the-counter markets
AbstractWe study financial markets where agents share risks, but have incentives to default and their financial positions might not be transparent, that is, might not be mutually observable. We show that a lack of position transparency results in a counterparty risk externality, that manifests itself in the form of excess “leverage,” in that parties take on short positions that lead to levels of default risk that are higher than Pareto efficient ones. This externality is absent when trading is organized via a centralized clearing mechanism that provides transparency of trade positions. Collateral requirements and especially subordination of non-transparent positions in bankruptcy can ameliorate the counterparty risk externality in market settings such as over-the-counter (OTC) markets which feature a lack of position transparency.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Economic Theory.
Volume (Year): 149 (2014)
Issue (Month): C ()
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Web page: http://www.elsevier.com/locate/inca/622869
Counterparty risk; Leverage; Transparency; Centralized clearing; Collateral; OTC markets;
Find related papers by JEL classification:
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
- G2 - Financial Economics - - Financial Institutions and Services
- G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
- D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
- D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
- D62 - Microeconomics - - Welfare Economics - - - Externalities
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