Market Structure, Counterparty Risk, and Systemic Risk

Abstract

We compare how bilaterally-cleared (OTC) and centrally-cleared derivatives markets react to an initial bankruptcy. We show these network structures exhibit economically different price impact, contagion, and volatility. In OTC markets, a large bankruptcy may prevent another counterparty from escaping expected bankruptcy and encourage predatory trading. OTC markets exhibit greater systemic risk, contagion, and distress volatility and are more prone to crises. The model suggests a key benefit of central clearing is coordinating trade in crises and that market fragility may be gauged by the number of counterparties, average risk aversion, standard deviation of total exposure, and market structure.

Keywords: central clearing, contagion, counterparty risk, systemic risk

JEL Classification: G01, G28, D49