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Collateralized networks

Author

Listed:
  • Ghamami, Samim
  • Glasserman, Paul
  • Young, Hobart

Abstract

This paper studies the spread of losses and defaults in financial networks with two interrelated features: collateral requirements and alternative contract termination rules. When collateral is committed to a firm’s counterparties, a solvent firm may default if it lacks sufficient liquid assets to meet its payment obligations. Collateral requirements can thus increase defaults and payment shortfalls. Moreover, one firm may benefit from the failure of another if the failure frees collateral committed by the surviving firm, giving it additional resources to make other payments. Contract termination at default may also improve the ability of other firms to meet their obligations through access to collateral. As a consequence of these features, the timing of payments and collateral liquidation must be carefully specified to establish the existence of payments that clear the network. Using this framework, we show that dedicated collateral may lead to more defaults than pooled collateral; we study the consequences of illiquid collateral for the spread of losses through fire sales; we compare networks with and without selective contract termination; and we analyze the impact of alternative resolution and bankruptcy stay rules that limit the seizure of collateral at default. Under an upper bound on derivatives leverage, full termination reduces payment shortfalls compared with selective termination.

Suggested Citation

  • Ghamami, Samim & Glasserman, Paul & Young, Hobart, 2022. "Collateralized networks," LSE Research Online Documents on Economics 107496, London School of Economics and Political Science, LSE Library.
  • Handle: RePEc:ehl:lserod:107496
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    File URL: http://eprints.lse.ac.uk/107496/
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    References listed on IDEAS

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    Cited by:

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    2. Hüser, Anne-Caroline & Lepore, Caterina & Veraart, Luitgard, 2021. "How does the repo market behave under stress? Evidence from the Covid-19 crisis," Bank of England working papers 910, Bank of England, revised 18 Jun 2021.
    3. Amini, Hamed & Feinstein, Zachary, 2023. "Optimal network compression," European Journal of Operational Research, Elsevier, vol. 306(3), pages 1439-1455.
    4. Jukonis, Audrius & Letizia, Elisa & Rousová, Linda, 2022. "The impact of derivatives collateralisation on liquidity risk: evidence from the investment fund sector," Working Paper Series 2756, European Central Bank.
    5. Inaki Aldasoro & Luitgard A M Veraart, 2022. "Systemic Risk in Markets with Multiple Central Counterparties," BIS Working Papers 1052, Bank for International Settlements.
    6. Zachary Feinstein & Andreas Sojmark, 2022. "Endogenous Distress Contagion in a Dynamic Interbank Model," Papers 2211.15431, arXiv.org, revised Sep 2023.

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    More about this item

    Keywords

    contagion; OTC markets; financial regulation; network; fire sales; collateral; automatic stays for qualified financial contracts;
    All these keywords.

    JEL classification:

    • J50 - Labor and Demographic Economics - - Labor-Management Relations, Trade Unions, and Collective Bargaining - - - General

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