Managing Counterparty Risk in OTC Markets
42 Pages Posted: 7 Sep 2017 Last revised: 29 Apr 2020
Date Written: 2017-08-15
We study how banks manage their default risk to optimally negotiate quantities and prices of contracts in over-the-counter markets. We show that costly actions exerted by banks to reduce their default probabilities are inefficient. Negative externalities due to counterparty concentration may lead banks to reduce their default probabilities even below the social optimum. The model provides new implications which are supported by empirical evidence: (i) intermediation is done by low-risk banks with medium initial exposure; (ii) the risk-sharing capacity of the market is impaired, even when the trade size limit is not binding; and (iii) intermediaries play the fundamental role of diversifying the idiosyncratic risk in CDS contracts, besides increasing the risk-sharing capacity of the market.
Keywords: Over-the-counter markets, Conterparty concentration, Counterparty risk, Negative externalities
JEL Classification: G11, G12, G21
Suggested Citation: Suggested Citation