Counterparty Risk Externality: Centralized Versus Over-the-counter Markets
We model the opacity of over-the-counter (OTC) markets in a setup where agents share risks, but have incentives to default and their financial positions are not mutually observable. We show that this setup results in excess "leverage" in that parties take on short OTC positions that lead to levels of default risk that are higher than Pareto-efficient ones. In particular, OTC markets feature a "counterparty risk externality" that we show can lead to ex-ante productive inefficiency. This externality is absent when trading is organized via a centralized clearing mechanism that provides transparency of trade positions, or a centralized counterparty (such as an exchange) that observes all trades and sets prices competitively. While collateral requirements and subordination of OTC positions in bankruptcy can ameliorate the counterparty risk externality, they are in general inadequate in addressing it fully.
|Date of creation:||Apr 2011|
|Date of revision:|
|Publication status:||published as “Counterparty Risk Externality: Centralized versus Over - the - counter Markets” with Alberto Bisin, Journal of Economic Theory , 2014, 149 , 153 - 182|
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