Counterparty Risk Externality: Centralized Versus Over-the-counter Markets
AbstractWe 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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Date of creation: Apr 2011
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- Viral Acharya & Alberto Bisin, 2011. "Counterparty risk externality: Centralized versus over-the-counter markets," 2011 Meeting Papers 618, Society for Economic Dynamics.
- D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
- D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
- D62 - Microeconomics - - Welfare Economics - - - Externalities
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
- G2 - Financial Economics - - Financial Institutions and Services
- G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-05-07 (All new papers)
- NEP-BAN-2011-05-07 (Banking)
- NEP-BEC-2011-05-07 (Business Economics)
- NEP-CBA-2011-05-07 (Central Banking)
- NEP-MIC-2011-05-07 (Microeconomics)
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Research Program in Finance, Working Paper Series
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