Managing Counterparty Risk in OTC Markets

Abstract

We study how banks manage their default risk before bilaterally negotiating the quantities and prices of over-the-counter (OTC) contracts resembling credit default swaps (CDSs). We show that the costly actions exerted by banks to reduce their default probabilities are not socially optimal. Depending on the imposed trade size limits, risk-management costs and sellers' bargaining power, banks may switch from choosing default risk levels above the social optimum to reducing them even below the social optimum. We use a unique and comprehensive data set of bilateral exposures from the CDS market to test the main model implications on the OTC market structure: (i) intermediation is done by low-risk banks with medium credit exposure; (ii) all banks with high credit exposures are net buyers of CDSs, and low-risk banks with low credit exposures are the main net sellers; and (iii) heterogeneity in post-trade credit exposures is higher for riskier banks and smaller for safer banks.

Collateralized Debt Networks with Lender Default

“…Finally, this paper is also related to the literature about central clearing. Duffie and Zhu (2011) started the formal discussion, which is extended by Duffie et al (2015), Arnold (2017), Frei et al (2017), Paddrik and Young (2017), and Paddrik et al (2019) analyzing the effect on systemic risk and margin dynamics under a CCP. Biais et al (2012) uses the search cost as the moral hazard problem of clearing members.…”

Compressing Over-the-Counter Markets

“…Other studies have analyzed counterparty risk pricing in OTC markets. Acharya and Bisin (2014) and Frei et al (2017) show that opacity and trade size limits usually prevent efficient risk pricing. While, in this paper, we study arbitrary sets of trading relationships, our results show that, under realistic assumptions, the adoption of post-trade technologies can largely impact the size of dealers -and the market as a whole -thus making OTC markets prone to rapid structural reconfigurations when participants coordinate.…”