Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk

Abstract

We analyze the role of transaction costs in risk transfer markets. For example, when these markets are in their infancy, they are characterized by few contracts and high transaction costs. In this case, we show that only highly risk-averse buyers (e.g., hedgers) exist in the market alongside high quality counterparties, and no asymmetric information can be present on either the quality of the risk being transferred or the quality of the counterparty to which the risk is ceded. With lower transaction costs, we show that less risk-averse buyers (e.g., speculators) will enter the market thereby increasing risk transfer; however, these buyers will choose to contract with less stable counterparties. When transaction costs are low, we show that asymmetric information on the quality of the risk being transferred and of the quality of the counterparties can exist in equilibrium. Asymmetric information regarding seller quality (counterparty risk) can raise prices and thus reduce speculation, but can also cause some buyers who would otherwise contract with stable sellers to contract with unstable ones rather than face uncertainty over seller type. Finally, we analyze the effect of a transaction tax, which is viewed simply as an increase in transaction costs. Such a tax is shown to push relatively less risk-averse buyers out of the market, which tends to reduce the relative number of unstable counterparties. In addition, we show that it reduces the rents that can be extracted due to asymmetric information.

Keywords: Risk Transfer, Transaction Costs, Counterparty risk, Transaction Taxes