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

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  • Viral V. Acharya
  • Alberto Bisin

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 this setup results in 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 competitively. While collateral requirements and subordination of OTC positions in bankruptcy can ameliorate the counterparty risk externality, they are in general inadequate in addressing it fully.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17000.

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Date of creation: Apr 2011
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Publication status: published as “Counterparty Risk Externality: Centralized versus Over - the - counter Markets” with Alberto Bisin, Journal of Economic Theory , 2014, 149 , 153 - 182
Handle: RePEc:nbr:nberwo:17000

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  1. Gregory R. Duffee & Chunsheng Zhou, 1997. "Credit derivatives in banking: useful tools for managing risk?," Finance and Economics Discussion Series 1997-13, Board of Governors of the Federal Reserve System (U.S.).
  2. James R. Thompson, 2010. "Counterparty Risk in Financial Contracts: Should the Insured Worry about the Insurer?," The Quarterly Journal of Economics, MIT Press, vol. 125(3), pages 1195-1252, August.
  3. Christine A. Parlour & Guillaume Plantin, 2008. "Loan Sales and Relationship Banking," Journal of Finance, American Finance Association, vol. 63(3), pages 1291-1314, 06.
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Cited by:
  1. Biais, Bruno & Heider, Florian & Hoerova, Marie, 2012. "Risk-sharing or risk-taking? Counterparty risk, incentives and margins," Working Paper Series 1413, European Central Bank.
  2. Castiglionesi, Fabio & Wagner, Wolf, 2013. "On the efficiency of bilateral interbank insurance," Journal of Financial Intermediation, Elsevier, vol. 22(2), pages 177-200.
  3. Gibson, Rajna & Murawski, Carsten, 2013. "Margining in derivatives markets and the stability of the banking sector," Journal of Banking & Finance, Elsevier, vol. 37(4), pages 1119-1132.
  4. Bruno Biais & Florian Heider & Marie Hoerova, 2012. "Clearing, Counterparty Risk, and Aggregate Risk," IMF Economic Review, Palgrave Macmillan, vol. 60(2), pages 193-222, July.

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