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

48 Pages Posted: 22 Mar 2010 Last revised: 9 Aug 2010

Viral V. Acharya

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

Alberto Bisin

New York University (NYU) - Department of Economics; New York University (NYU) - Center for Experimental Social Science (CESS); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: 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.

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

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

Suggested Citation

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

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 Economic Policy Research (CEPR)

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London, EC1V 3PZ
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National Bureau of Economic Research (NBER)

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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 (NYU) - Department of Economics

14 West 4th Street
New York, NY 10012
United States

New York University (NYU) - Center for Experimental Social Science (CESS) ( email )

One Washington Place
New York, NY 10003
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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