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

Viral Acharya and Alberto Bisin

Journal of Economic Theory, 2014, vol. 149, issue C, 153-182

Abstract: We study financial markets where agents share risks, but have incentives to default and their financial positions might not be transparent, that is, might not be mutually observable. We show that a lack of position transparency results in a counterparty risk externality, that manifests itself in the form of excess “leverage,” in that parties take on short positions that lead to levels of default risk that are higher than Pareto efficient ones. This externality is absent when trading is organized via a centralized clearing mechanism that provides transparency of trade positions. Collateral requirements and especially subordination of non-transparent positions in bankruptcy can ameliorate the counterparty risk externality in market settings such as over-the-counter (OTC) markets which feature a lack of position transparency.

Keywords: Counterparty risk; Leverage; Transparency; Centralized clearing; Collateral; OTC markets (search for similar items in EconPapers)
JEL-codes: D52 D53 D62 G14 G2 G33 (search for similar items in EconPapers)
Date: 2014
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (98)

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Related works:
Working Paper: Counterparty Risk Externality: Centralized Versus Over-the-counter Markets (2011)
Working Paper: Counterparty risk externality: Centralized versus over-the-counter markets (2011)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jetheo:v:149:y:2014:i:c:p:153-182

DOI: 10.1016/j.jet.2013.07.001

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