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

No 618, 2011 Meeting Papers from Society for Economic Dynamics

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.

Date: 2011
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Citations: View citations in EconPapers (8)

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Related works:
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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