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

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 ongoing financial crisis. We model such OTC markets for risk-sharing in a general equilibrium setup where agents 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 centralized counterparty such as an exchange that observes all trades and sets prices.

Number of Pages in PDF File: 48

Keywords: OTC markets, leverage, counterparty risk, externality, transparency, centralized clearing, exchange

JEL Classification: G14, G2, G33, D52, D53, D62

working papers series