Collateralized Networks

Samim Ghamami (), Paul Glasserman () and H. Peyton Young ()
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Samim Ghamami: University of California, Berkeley, Berkeley, California 94720; New York University, New York, New York 10012; Financial Services Forum, Washington, District of Columbia 20005
Paul Glasserman: Columbia Business School, New York, New York 10027
H. Peyton Young: London School of Economics, London WC2A 2AE, United Kingdom; University of Oxford, Oxford OX1 2JD, United Kingdom

Management Science, 2022, vol. 68, issue 3, 2202-2225

Abstract: This paper studies the spread of losses and defaults in financial networks with two interrelated features: collateral requirements and alternative contract termination rules. When collateral is committed to a firm’s counterparties, a solvent firm may default if it lacks sufficient liquid assets to meet its payment obligations. Collateral requirements can, thus, increase defaults and payment shortfalls. Moreover, one firm may benefit from the failure of another if the failure frees collateral committed by the surviving firm, giving it additional resources to make other payments. Contract termination at default may also improve the ability of other firms to meet their obligations through access to collateral. As a consequence of these features, the timing of payments and collateral liquidation must be carefully specified to establish the existence of payments that clear the network. Using this framework, we show that dedicated collateral may lead to more defaults than pooled collateral, we study the consequences of illiquid collateral for the spread of losses through fire sales, we compare networks with and without selective contract termination, and we analyze the impact of alternative resolution and bankruptcy stay rules that limit the seizure of collateral at default. Under an upper bound on derivatives leverage, full termination reduces payment shortfalls compared with selective termination.

Keywords: contagion; OTC markets; financial regulation; network; fire sales; collateral; automatic stays for qualified financial contracts (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (9)

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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:68:y:2022:i:3:p:2202-2225

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