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Endogenous Derivative Networks

Author

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  • Vuillemey, G.
  • Breton, R.

Abstract

This paper proposes a network formation model of an OTC derivatives market where both prices and quantities are bilaterally negociated. The key feature of the framework is to endogenize the network of exposures, the gross and net notional amounts traded and the collateral delivered through initial and variation margins, as a function of idiosyncratic counterparty risk and regulatory collateral and clearing requirements. Using the framework, we investigate numerically the size of the derivatives network, the aggregate collateral demand and the pricing of the contracts under the following schemes: (i) various levels of collateralization for uncleared transactions, (ii) rehypothecation of received collateral and (iii) clearing through a central clearing party (CCP). Overall results suggest that dynamic effects due to the endogeneity of the derivative network to the collateralization and clearing requirements have sizeable consequences on both contract volumes and prices. Intermediary trading and market liquidity are reduced by higher collateralization requirements and enhanced by rehypothecation, while the potential for contagion is reduced. Not accounting for dynamic effects in current market conditions may lead to over-estimate collateral demand induced by mandatory central clearing by up to 22%.

Suggested Citation

  • Vuillemey, G. & Breton, R., 2014. "Endogenous Derivative Networks," Working papers 483, Banque de France.
  • Handle: RePEc:bfr:banfra:483
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    References listed on IDEAS

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    Cited by:

    1. Tomas Klinger & Petr Teply, 2016. "The Nexus Between Systemic Risk and Sovereign Crises," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 66(1), pages 50-69, February.
    2. Maryam Farboodi, 2014. "Intermediation and Voluntary Exposure to Counterparty Risk," 2014 Meeting Papers 365, Society for Economic Dynamics.
    3. Bluhm, Marcel, 2018. "Persistent liquidity shocks and interbank funding," Journal of Financial Stability, Elsevier, vol. 36(C), pages 246-262.
    4. Blasques, Francisco & Bräuning, Falk & Lelyveld, Iman van, 2018. "A dynamic network model of the unsecured interbank lending market," Journal of Economic Dynamics and Control, Elsevier, vol. 90(C), pages 310-342.
    5. Zhuo Zhong & Kei Kawakami, 2016. "The Risk Sharing BenefiÂ…t versus the Collateral Cost: The Formation of the Inter-Dealer Network in Over-the-Counter Trading," 2016 Meeting Papers 822, Society for Economic Dynamics.
    6. Paul Glasserman & Peyton Young, 2015. "Contagion in Financial Networks," Economics Series Working Papers 764, University of Oxford, Department of Economics.
    7. Bennani, T. & Després, M. & Dujardin, M. & Duprey, T. & Kelber, A., 2014. "Macroprudential framework:key questions applied to the French case," Occasional papers 9, Banque de France.
    8. Farboodi, Maryam, 2017. "Comment on network reactions to banking regulations by Selman Erol and Guillermo Ordonez," Journal of Monetary Economics, Elsevier, vol. 89(C), pages 68-70.
    9. Paul Glasserman & H. Peyton Young, 2016. "Contagion in Financial Networks," Journal of Economic Literature, American Economic Association, vol. 54(3), pages 779-831, September.
    10. Paul Glasserman & H. Peyton Young, 2015. "Contagion in Financial Markets," Working Papers 15-21, Office of Financial Research, US Department of the Treasury.

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    More about this item

    Keywords

    Collateral; Credit derivatives; Central Clearing Party (CCP); Rehypothecation; Network formation.;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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