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Counterparty risk externality: Centralized versus over-the-counter markets

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  • Acharya, Viral
  • Bisin, Alberto
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    Abstract

    We 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 Info

    Article provided by Elsevier in its journal Journal of Economic Theory.

    Volume (Year): 149 (2014)
    Issue (Month): C ()
    Pages: 153-182

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    Handle: RePEc:eee:jetheo:v:149:y:2014:i:c:p:153-182

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    Web page: http://www.elsevier.com/locate/inca/622869

    Related research

    Keywords: Counterparty risk; Leverage; Transparency; Centralized clearing; Collateral; OTC markets;

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    References

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    1. Viral V. Acharya & Alberto Bisin, 2009. "Managerial hedging, equity ownership, and firm value," RAND Journal of Economics, RAND Corporation, vol. 40(1), pages 47-77.
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      • Alberto Bisin & John Geanakoplos & Piero Gottardi & Enrico Minelli & Heracles Polemarchakis, 2009. "Markets and Contracts," Working Papers 0915, University of Brescia, Department of Economics.
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    Cited by:
    1. Arnold, Marc, . "Banks’ Loan Screening Incentives with Credit Risk Transfer: An Alternative to Risk Retention," Working Papers on Finance 1402, University of St. Gallen, School of Finance.
    2. Allen, Franklin & Vayanos, Dimitri & Vives, Xavier, 2014. "Introduction to financial economics," Journal of Economic Theory, Elsevier, vol. 149(C), pages 1-14.

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