Abstract

http://ssrn.com/abstract=1573355
 
 

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


Viral V. Acharya


New York University - Leonard N. Stern School of Business; Centre for International Finance and Regulation (CIFR); Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance

Alberto Bisin


New York University - Leonard N. Stern School of Business - Department of Economics

June 2010


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

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Date posted: March 22, 2010 ; Last revised: August 9, 2010

Suggested Citation

Acharya, Viral V. and Bisin, Alberto, Counterparty Risk Externality: Centralized Versus Over-The-Counter Markets (June 2010). Available at SSRN: http://ssrn.com/abstract=1573355 or http://dx.doi.org/10.2139/ssrn.1573355

Contact Information

Viral V. Acharya (Contact Author)
New York University - Leonard N. Stern School of Business ( email )
44 West 4th Street
New York, NY NY 10012
United States
HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm
Centre for International Finance and Regulation (CIFR) ( email )
Level 7, UNSW CBD Campus
1 O'Connell Street
Sydney, NSW 2000
Australia

Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
New York University (NYU) - Department of Finance
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
Alberto Bisin
New York University - Leonard N. Stern School of Business - Department of Economics ( email )
269 Mercer Street
New York, NY 10003
United States
212-998-8916 (Phone)
212-995-4186 (Fax)
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