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Dealers' Insurance, Market Structure And Liquidity

Author

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  • Cyril Monnet

    (Universitat Bern)

  • Francesca Carapella

    (Federal Reserve Board)

Abstract

Dealers intermediate transactions between buyers and sellers in many markets. In particular this is true in nancial markets where many contracts are over-the-counter (OTC), especially derivatives: they are negotiated bilaterally and subject their users to the risk of counterparty default. Nearly all OTC derivatives today are negotiated between a dealer and end users. Beginning in the late 1990's, some derivatives negotiated OTC, began to be cleared and settled through central counterparties (CCPs): by interposing itself as the counterparty of record for all transactions, the CCP protects trading participants from both settlement risk and replacement cost losses arising from a counterparty default. Since then, OTC-cleared derivatives volume has grown steadily in those and several other clearinghouses; however, many market participants still prefer traditional OTC derivatives (with bilateral credit risk management). Then a question naturally arises: why in certain markets and for certain transactions CCPs are not used? This is the rst question that this paper answers. In the wake of the credit crisis of 2007 and 2008, policy makers developed an elevated interest in CCP clearing and settlement solutions for OTC derivatives, culminated with the Dodd-Frank Act passed on July 21, 2010. As part of the new regulatory framework for OTC derivatives, the Dodd-Frank Act mandates that many OTC derivatives transactions be cleared and settled through regulated CCPs. In essence, clearing via CCPs reallocates the risk of loss arising from non-performance in derivatives transactions. This reallocation, however, may aect the behavior of market participants and the structure of the market. This is the second question that this paper answers: it studies the eect that the provision of counterparty risk insurance to dealers has on market liquidity and market structure. We interpret our insurance mechanism as the introduction of a central counterparty. Contrary to most papers in the literature, we analyze how insurance will impact the trading behavior of incumbents dealers as well as the effect on dealers' entry. We nd that more counterparty risk shifts trading toward more efficient dealers, who are the incumbents: so these dealers would reject the introduction of an insurance as it allows more (and relatively inefficient) dealers to enter the market, thus lowering their market power. As a result, insurance implies a decrease in the bid-ask spread. This feature of the equilibrium shows a trade o for end users: they benet from the reduction of the bid-ask spread, but they lose from facing on average less efficient dealers. Therefore, whether the overall welfare generated by the industry increases with the insurance or not, depends on which of the two effects dominates.

Suggested Citation

  • Cyril Monnet & Francesca Carapella, 2013. "Dealers' Insurance, Market Structure And Liquidity," 2013 Meeting Papers 1144, Society for Economic Dynamics.
  • Handle: RePEc:red:sed013:1144
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