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The impact of a dealer's failure on OTC derivatives market liquidity during volatile periods


  • Larry D. Wall
  • Ellis W. Tallman
  • Peter A. Abken


This paper develops a model in which information losses may be an important part of the cost of an OTC derivatives dealer's failure. A dealer failure forces solvent counterparties of a failed dealer to seek replacement hedges with other dealers. However, by forcing good firms into the derivatives market, the failure provides camouflage for insolvent firms seeking to speculate with a dealer that does not know their credit status. The paper models this information loss and uses the model to quantitatively evaluate a range of scenarios. The results suggest that a market breakdown is unlikely but not quite impossible.

Suggested Citation

  • Larry D. Wall & Ellis W. Tallman & Peter A. Abken, 1996. "The impact of a dealer's failure on OTC derivatives market liquidity during volatile periods," FRB Atlanta Working Paper 96-6, Federal Reserve Bank of Atlanta.
  • Handle: RePEc:fip:fedawp:96-6

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    References listed on IDEAS

    1. Meng, Chun-Lo & Schmidt, Peter, 1985. "On the Cost of Partial Observability in the Bivariate Probit Model," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(1), pages 71-85, February.
    2. Gorton, Gary & Huang, Lixin, 2006. "Bank panics and the endogeneity of central banking," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1613-1629, October.
    3. Selgin, G., 1993. "In Defence of Bank Suspension," Papers 367, Georgia - College of Business Administration, Department of Economics.
    4. Milton Friedman & Anna J. Schwartz, 1963. "A Monetary History of the United States, 1867–1960," NBER Books, National Bureau of Economic Research, Inc, number frie63-1, January.
    5. Economopoulos, Andrew J, 1988. "Illinois Free Banking Experience," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 20(2), pages 249-264, May.
    6. Rolnick, Arthur J. & Weber, Warren E., 1984. "The causes of free bank failures : A detailed examination," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 267-291, November.
    7. Hasan, Iftekhar & Dwyer, Gerald P, Jr, 1994. "Bank Runs in the Free Banking Period," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 26(2), pages 271-288, May.
    8. Poirier, Dale J., 1980. "Partial observability in bivariate probit models," Journal of Econometrics, Elsevier, vol. 12(2), pages 209-217, February.
    9. Gorton, Gary, 1996. "Reputation Formation in Early Bank Note Markets," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 346-397, April.
    10. Neil Wallace, 1990. "A banking model in which partial suspension is best," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 11-23.
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    Cited by:

    1. Wall, Larry D. & Eisenbeis, Robert A. & Frame, W. Scott, 2005. "Resolving large financial intermediaries: Banks versus housing enterprises," Journal of Financial Stability, Elsevier, vol. 1(3), pages 386-425, April.
    2. Hentschel, Ludger & Smith, Clifford Jr., 1997. "Derivatives regulation: Implications for central banks," Journal of Monetary Economics, Elsevier, vol. 40(2), pages 305-346, October.
    3. Darrell, Duffie, 2010. "The Failure Mechanics of Dealer Banks," Economic Policy, Russian Presidential Academy of National Economy and Public Administration, vol. 4, pages 131-153.


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