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Counterparty Risk Externality: Centralized Versus Over-the-counter Markets

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  • Viral V. Acharya
  • Alberto Bisin

Abstract

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.

Suggested Citation

  • Viral V. Acharya & Alberto Bisin, 2011. "Counterparty Risk Externality: Centralized Versus Over-the-counter Markets," NBER Working Papers 17000, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:17000
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    References listed on IDEAS

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    1. Alberto Bisin & Danilo Guaitoli, 2004. "Moral Hazard and Nonexclusive Contracts," RAND Journal of Economics, The RAND Corporation, vol. 35(2), pages 306-328, Summer.
    2. Darrell Duffie & Nicolae Gârleanu & Lasse Heje Pedersen, 2007. "Valuation in Over-the-Counter Markets," Review of Financial Studies, Society for Financial Studies, vol. 20(6), pages 1865-1900, November.
    3. Bisin, Alberto & Rampini, Adriano A., 2006. "Markets as beneficial constraints on the government," Journal of Public Economics, Elsevier, vol. 90(4-5), pages 601-629, May.
    4. Alberto Bisin & Adriano Rampini, 2006. "Exclusive contracts and the institution of bankruptcy," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 27(2), pages 277-304, January.
    5. Pradeep Dubey & John Geanakoplos & Martin Shubik, 2005. "Default and Punishment in General Equilibrium," Econometrica, Econometric Society, vol. 73(1), pages 1-37, January.
    6. Darrell Duffie, 2012. "Over-The-Counter Markets," Introductory Chapters,in: Dark Markets: Asset Pricing and Information Transmission in Over-the-Counter Markets Princeton University Press.
    7. Duffee, Gregory R. & Zhou, Chunsheng, 2001. "Credit derivatives in banking: Useful tools for managing risk?," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 25-54, August.
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    9. Christine A. Parlour & Guillaume Plantin, 2008. "Loan Sales and Relationship Banking," Journal of Finance, American Finance Association, vol. 63(3), pages 1291-1314, June.
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    11. Acharya, Viral V. & Johnson, Timothy C., 2007. "Insider trading in credit derivatives," Journal of Financial Economics, Elsevier, vol. 84(1), pages 110-141, April.
    12. Viral V. Acharya & Alberto Bisin, 2009. "Managerial hedging, equity ownership, and firm value," RAND Journal of Economics, RAND Corporation, vol. 40(1), pages 47-77.
    13. Ricardo J. Caballero & Alp Simsek, 2009. "Complexity and Financial Panics," NBER Working Papers 14997, National Bureau of Economic Research, Inc.
    14. Bizer, David S & DeMarzo, Peter M, 1992. "Sequential Banking," Journal of Political Economy, University of Chicago Press, vol. 100(1), pages 41-61, February.
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    16. James R. Thompson, 2010. "Counterparty Risk in Financial Contracts: Should the Insured Worry About the Insurer?," The Quarterly Journal of Economics, Oxford University Press, vol. 125(3), pages 1195-1252.
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    More about this item

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G2 - Financial Economics - - Financial Institutions and Services
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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