Default Risk Mitigation in Derivatives Markets and its Effectiveness
Posted: 9 Jun 2006
Date Written: April 2006
Derivatives have become an integral part of the major financial institutions' business and the global derivatives market has grown into the largest market in the world by far. As for any other contract, derivatives are subject to default risk. The set of mechanisms employed by traders to mitigate default risk, such as netting and margining, vary across market types. While exchanges have not experienced any notable credit events in the recent past, over-the-counter markets suffered several, almost systemic events. It seems that the sets of default risk mitigation mechanisms employed by exchanges are more effective at mitigating default risk than those employed by over-the-counter markets.
The broader impacts of these mitigation mechanisms are not yet fully understood, though. In this paper we analyze the effect of different default risk mitigation mechanisms on wealth, market liquidity, and default rates.
We develop a model to investigate the effects of default risk mitigation mechanisms on market, credit, and liquidity risk. Our model captures some of the main characteristics of derivatives markets. The dynamic and non-linear nature of our problem, of liquidity and default in particular, render a formal modelling approach unpromising. We therefore use simulations to evaluate our model.
We find that there exist situations where default risk mitigation mechanisms reduce market liquidity, increase default rates as well as default severity, and the variance of agents' wealth. Such situations include periods of market stress. This means that default risk mitigation mechanisms might have a negative effect on wealth at times when market participants expect them to be most valuable.
Keywords: Derivative securities, over-the-counter markets, default risk, systemic risk, central counterparty
JEL Classification: G19, G21
Suggested Citation: Suggested Citation