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

Author

Listed:
  • Viral Acharya

    (NYU Stern)

  • Alberto Bisin

    (NYU Economics)

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.

Suggested Citation

  • Viral Acharya & Alberto Bisin, 2011. "Counterparty risk externality: Centralized versus over-the-counter markets," 2011 Meeting Papers 618, Society for Economic Dynamics.
    • Handle: RePEc:red:sed011:618
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    References listed on IDEAS

    as
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    More about this item

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G2 - Financial Economics - - Financial Institutions and Services
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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