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

  title={Counterparty Risk Externality: Centralized Versus Over-the-Counter Markets},
  author={Viral Acharya and Alberto Bisin},
  journal={Microeconomics: Production},
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… 
The Design of a Central Counterparty
This paper studies the benefits of central clearing and the design of a central counterparty (CCP) with an optimal contracting approach. Investors sign contracts to hedge an underlying exposure. There
The Demand for Central Clearing: To Clear or Not to Clear, that is the Question
This paper is a first attempt at empirically analyzing whether post-crisis regulatory reforms have created appropriate incentives to voluntarily centrally clear Over-The-Counter (OTC) derivative
Counterparty risk, central counterparty clearing and aggregate risk
I construct a model of bilateral trading of over-the-counter (OTC) derivatives to study the performance of central counterparty (CCP) clearing. I first show how buyers are exposed to counterparty
The Double Bind of Asymmetric Information in Over-the-Counter Markets
In over-the-counter markets with heterogeneous asset qualities and individual valuations, private information about both of these value components amplifies the adverse selection problem attributable
Optimal Collateralization with Bilateral Default Risk
We consider over-the-counter (OTC) transactions with bilateral default risk, and study the optimal design of the Credit Support Annex (CSA). In a setting where agents have access to a trading
Clearing, transparency, and collateral
In an environment of Over-The-Counter trading with adverse selection we study traders' incentives to screen their counterparties under different clearing arrangements. When the clearing arrangement
Lemons and Proud of It : Information Asymmetry and Risk Transfer Markets
In this paper we analyze asymmetric information in risk transfer markets. We extend the financial markets literature to allow for counterparty risk in an intermediated market and analyze the
Over-the-Counter versus Limit-Order Markets: The Role of Traders’ Expertise
Over-the-counter (OTC) markets attract substantial trading volume despite exhibiting frictions absent in centralized limit-order markets. We compare the efficiency of OTC and limit-order markets
Risk-Sharing or Risk-Taking? Counterparty Risk, Incentives and Margins
We analyze optimal hedging contracts and show that although hedging aims at sharing risk, it can lead to more risk-taking. News implying that a hedge is likely to be loss-making undermines the
Information Asymmetry and Risk Transfer Markets
We provide a tractable model of counterparty risk in an intermediated risk transfer market, and analyze the consequences of this risk being private information. We show that unknown type information


The Economics of Clearing in Derivatives Markets: Netting, Asymmetric Information, and the Sharing of Default Risks Through a Central Counterparty
Credit derivatives have received intense scrutiny -- and criticism -- as a major contributor to the ongoing financial crisis. In response, regulators have proposed requiring the formation of a
Making Over-the-Counter Derivatives Safer: The Role of Central Counterparties
summary I n an effort to improve market infrastructure following the crisis, central counterparties (CCPs) are being put forth as the way to make over-the-counter (OTC) derivatives markets safer and
Insider Trading in Credit Derivatives
Insider trading in the credit derivatives market has become a significant concern for regulators and participants. This paper attempts to quantify the problem. Using news reflected in the stock
Entangled Financial Systems
I model an entangled financial system in which banks hedge their portfolio risks using over-the-counter (OTC) contracts. However, banks choose not to hedge counterparty risk, and thus the
Over-the-Counter Markets
We study how intermediation and asset prices in over-the-counter markets are affected by illiquidity associated with search and bargaining. We compute explicitly the prices at which investors trade
CDS as Insurance: Leaky Lifeboats in Stormy Seas
What market features of financial risk transfer exacerbate counterparty risk? To analyze this, we formulate a model which elucidates important differences between financial risk transfer and
Netting, Financial Contracts, and Banks: The Economic Implications
Derivatives and certain other off-balance sheet contracts enjoy special legal protection on insolvent counterparties through a process referred to as 'close-out netting.' This paper explores the
Entangled Financial Systems JOB MARKET PAPER
This paper analyzes counterparty risk in entangled financial systems. The system is “entangled” because banks hedge risks using a network of bilateral over-the-counter contracts. If banks have large
Default and Punishment in General Equilibrium
We extend the standard model of general equilibrium with incomplete markets to allow for default and punishment by thinking of assets as pools. The equilibrating variables include expected delivery
Counterparty Risk in Financial Contracts: Should the Insured Worry About the Insurer?
We analyze the effect of counterparty risk on financial insurance contracts, using the case of credit risk transfer in banking. This paper posits a new moral hazard problem on the insurer side of the