Counterparty Risk Externality: Centralized Versus Over-The-Counter Markets
The authors model the opacity of Over-The-Counter (OTC) markets in a setup where agents share risks, but have incentives to default and their financial positions are not mutually observable. They show that this setup results in excess "Leverage" in that parties take on short OTC positions that lead to levels of default risk that are higher than Pareto-efficient ones. In particular, OTC markets feature a "Counterparty risk externality" that they show can lead to ex-ante productive inefficiency. This externality is absent when trading is organized via a centralized clearing mechanism that provides transparency of trade positions, or a centralized counterparty (such as an exchange) that observes all trades and sets prices competitively.