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

Author

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

Abstract

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.
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Suggested Citation

  • Peter A. Abken & Ellis W. Tallman & Larry D. Wall, 1997. "The impact of a dealer's failure on OTC derivatives market liquidity during volatile periods," Proceedings 555, Federal Reserve Bank of Chicago.
    • Handle: RePEc:fip:fedhpr:555
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    References listed on IDEAS

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    1. Joseph P. Hughes & William W. Lang & Loretta J. Mester & Choon-Geol Moon, 1996. "Efficient banking under interstate branching," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 1045-1075.
    2. Joseph P. Hughes & William Lang & Loretta J. Mester & Choon-Geol Moon, 1995. "Recovering Technologies that Account for Generalized Managerial Preferences: An Application to Non-Risk-Neutral Banks," Center for Financial Institutions Working Papers 95-16, Wharton School Center for Financial Institutions, University of Pennsylvania.
    3. Jondrow, James & Knox Lovell, C. A. & Materov, Ivan S. & Schmidt, Peter, 1982. "On the estimation of technical inefficiency in the stochastic frontier production function model," Journal of Econometrics, Elsevier, vol. 19(2-3), pages 233-238, August.
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    Cited by:

    1. is not listed on IDEAS
    2. 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.
    3. Hentschel, Ludger & Smith, Clifford Jr., 1997. "Derivatives regulation: Implications for central banks," Journal of Monetary Economics, Elsevier, vol. 40(2), pages 305-346, October.
    4. Darrell Duffie, 2010. "The Failure Mechanics of Dealer Banks," Journal of Economic Perspectives, American Economic Association, vol. 24(1), pages 51-72, Winter.

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