Counterparty risk externality: Centralized versus over-the-counter markets

Viral Acharya, Alberto Bisin

    Research output: Contribution to journalArticlepeer-review

    Abstract

    We study financial markets where agents share risks, but have incentives to default and their financial positions might not be transparent, that is, might not be mutually observable. We show that a lack of position transparency results in a counterparty risk externality, that manifests itself in the form of excess "leverage," in that parties take on short positions that lead to levels of default risk that are higher than Pareto efficient ones. This externality is absent when trading is organized via a centralized clearing mechanism that provides transparency of trade positions. Collateral requirements and especially subordination of non-transparent positions in bankruptcy can ameliorate the counterparty risk externality in market settings such as over-the-counter (OTC) markets which feature a lack of position transparency.

    Original languageEnglish (US)
    Pages (from-to)153-182
    Number of pages30
    JournalJournal of Economic Theory
    Volume149
    Issue number1
    DOIs
    StatePublished - Jan 2014

    Keywords

    • Centralized clearing
    • Collateral
    • Counterparty risk
    • Leverage
    • OTC markets
    • Transparency

    ASJC Scopus subject areas

    • Economics and Econometrics

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