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Market structure, counterparty risk, and systemic risk

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  • Rosenthal, Dale W.R.

Abstract

Networks modeling bilaterally-cleared and centrally-cleared derivatives markets are shown to yield economically different price impact, volatility and contagion after an initial bankruptcy. A large bankruptcy in bilateral markets may leave a counterparty unable to expectationally prevent bankruptcy (checkmate) or make counterparties push markets and profit from contagion (hunting). In distress, bilateral markets amplify systemic risk and volatility versus centralized markets and are more subject to crises with real effects: contagion, unemployment, reduced tax revenue, higher transactions costs, lower risk sharing, and reduced allocative efficiency. Pricing distress volatility may suggest when to transition to central clearing. The model suggests three metrics for the well-connected part of a market -- number of counterparties, average risk aversion, and standard deviation of total exposure -- may characterize its fragility.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 36786.

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Date of creation: 10 Jun 2009
Date of revision: 19 Dec 2011
Handle: RePEc:pra:mprapa:36786

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Keywords: network model; systemic risk; contagion; predatory trading;

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  1. Heider, F. & Hoerova, M. & Holthausen, C., 2009. "Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk," Discussion Paper, Tilburg University, Center for Economic Research 2009-40 S, Tilburg University, Center for Economic Research.
  2. Gai, Prasanna & Kapadia, Sujit, 2010. "Contagion in financial networks," Bank of England working papers, Bank of England 383, Bank of England.
  3. Ben S. Bernanke, 1983. "Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression," NBER Working Papers 1054, National Bureau of Economic Research, Inc.
  4. Lasse Heje Pederson & Markus K Brunnermeier, 2007. "Market Liquidity and Funding Liquidity," FMG Discussion Papers, Financial Markets Group dp580, Financial Markets Group.
  5. Nier, Erlend & Yang, Jing & Yorulmazer, Tanju & Alentorn, Amadeo, 2008. "Network models and financial stability," Bank of England working papers, Bank of England 346, Bank of England.
  6. Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, Econometric Society, vol. 72(4), pages 1023-1061, 07.
  7. Gur Huberman & Werner Stanzl, 2004. "Price Manipulation and Quasi-Arbitrage," Econometrica, Econometric Society, Econometric Society, vol. 72(4), pages 1247-1275, 07.
  8. Lamoureux, Christopher G & Lastrapes, William D, 1990. "Persistence in Variance, Structural Change, and the GARCH Model," Journal of Business & Economic Statistics, American Statistical Association, American Statistical Association, vol. 8(2), pages 225-34, April.
  9. repec:ecb:ecbwps:20111413 is not listed on IDEAS
  10. Rodrigo Cifuentes & Hyun Song Shin & Gianluigi Ferrucci, 2005. "Liquidity Risk and Contagion," Journal of the European Economic Association, MIT Press, MIT Press, vol. 3(2-3), pages 556-566, 04/05.
  11. Biais, Bruno & Heider, Florian & Hoerova, Marie, 2012. "Risk-sharing or risk-taking? Counterparty risk, incentives and margins," Working Paper Series, European Central Bank 1413, European Central Bank.
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