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

Viral Acharya and Alberto Bisin

No 17000, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: D52 D53 D62 G14 G2 G33 (search for similar items in EconPapers)
Date: 2011-04
New Economics Papers: this item is included in nep-ban, nep-bec, nep-cba and nep-mic
Note: AP
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (13)

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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Journal Article: Counterparty risk externality: Centralized versus over-the-counter markets (2014)
Working Paper: Counterparty risk externality: Centralized versus over-the-counter markets (2011)
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