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Counterparty risk externality: Centralized versus over-the-counter markets

Author

Listed:
  • Viral Acharya

    (NYU Stern)

  • Alberto Bisin

    (NYU Economics)

Abstract

The opacity of over-the-counter (OTC) markets, in which a large number of financial products including credit derivatives trade, appears to have played a central role in the nancial crisis in 2007-09. We model such opacity of OTC markets in a general equilibrium setup where agents share risks, but have incentives to default and their financial positions are not mutually observable. We show that in this setting, there is excess leverage, in that parties in OTC contracts take on short 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.

Suggested Citation

  • Viral Acharya & Alberto Bisin, 2011. "Counterparty risk externality: Centralized versus over-the-counter markets," 2011 Meeting Papers 618, Society for Economic Dynamics.
  • Handle: RePEc:red:sed011:618
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    References listed on IDEAS

    as
    1. Ricardo J. Caballero & Alp Simsek, 2009. "Complexity and Financial Panics," NBER Working Papers 14997, National Bureau of Economic Research, Inc.
    2. Alberto Bisin & Danilo Guaitoli, 1998. "Moral hazard and non-exclusive contracts," Economics Working Papers 345, Department of Economics and Business, Universitat Pompeu Fabra.
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    4. Darrell Duffie & Nicolae Gârleanu & Lasse Heje Pedersen, 2007. "Valuation in Over-the-Counter Markets," Review of Financial Studies, Society for Financial Studies, pages 1865-1900.
    5. Bisin, Alberto & Rampini, Adriano A., 2006. "Markets as beneficial constraints on the government," Journal of Public Economics, Elsevier, pages 601-629.
    6. Bizer, David S & DeMarzo, Peter M, 1992. "Sequential Banking," Journal of Political Economy, University of Chicago Press, vol. 100(1), pages 41-61, February.
    7. Alberto Bisin & Adriano Rampini, 2006. "Exclusive contracts and the institution of bankruptcy," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), pages 277-304.
    8. Tano Santos & Jose A. Scheinkman, 2001. "Competition among Exchanges," The Quarterly Journal of Economics, Oxford University Press, pages 1027-1061.
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    10. 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.
    11. Cantillo, Miguel & Wright, Julian, 2000. "How Do Firms Choose Their Lenders? An Empirical Investigation," Review of Financial Studies, Society for Financial Studies, pages 155-189.
    12. Franklin Allen & Ana Babus & Elena Carletti, 2010. "Financial Connections and Systemic Risk," NBER Chapters,in: Market Institutions and Financial Market Risk National Bureau of Economic Research, Inc.
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    14. Christine A. Parlour & Guillaume Plantin, 2008. "Loan Sales and Relationship Banking," Journal of Finance, American Finance Association, vol. 63(3), pages 1291-1314, June.
    15. Duffee, Gregory R. & Zhou, Chunsheng, 2001. "Credit derivatives in banking: Useful tools for managing risk?," Journal of Monetary Economics, Elsevier, pages 25-54.
    16. Acharya, Viral V. & Johnson, Timothy C., 2007. "Insider trading in credit derivatives," Journal of Financial Economics, Elsevier, pages 110-141.
    17. Christine A. Parlour & Uday Rajan, 2001. "Competition in Loan Contracts," American Economic Review, American Economic Association, pages 1311-1328.
    18. 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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    20. 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.
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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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