Market structure, counterparty risk, and systemic risk

Rosenthal, Dale W.R. (2011): Market structure, counterparty risk, and systemic risk.

Abstract

Networks modeling bilaterally-cleared and centrally-cleared derivatives markets are shown to yield economically different price impact, volatility and contagion after an initial bankruptcy. A large bankruptcy in bilateral markets may leave a counterparty unable to expectationally prevent bankruptcy (checkmate) or make counterparties push markets and profit from contagion (hunting). In distress, bilateral markets amplify systemic risk and volatility versus centralized markets and are more subject to crises with real effects: contagion, unemployment, reduced tax revenue, higher transactions costs, lower risk sharing, and reduced allocative efficiency. Pricing distress volatility may suggest when to transition to central clearing. The model suggests three metrics for the well-connected part of a market -- number of counterparties, average risk aversion, and standard deviation of total exposure -- may characterize its fragility.

• Item Type: MPRA Paper
• Language: English
• Keywords: network model; systemic risk; contagion; predatory trading
• Subjects: G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation; G - Financial Economics > G0 - General > G01 - Financial Crises; D - Microeconomics > D4 - Market Structure, Pricing, and Design > D49 - Other

References

Acharya, Viral V., Robert F. Engle, Stephen Figlewski, Anthony W. Lynch, and Marti G. Subrahmanyam, 2009, Centralized clearing for credit derivatives, in Viral V. Acharya, and Matthew Richardson, ed.: Restoring Financial Stability (Wiley: New York, NY).

Allen, Franklin, and Douglas Gale, 2000, Financial contagion, Journal of Political Economy 108, 1–33.

Allen, Franklin, and Douglas Gale, 2004, Financial intermediaries and markets, Econometrica 72, 1023–1061.

Almgren, Robert, and Neil Chriss, 2001, Optimal execution of portfolio transactions, Journal of Risk 3, 5–39.

Bernanke, Ben S., 1983, Nonmonetary effects of the financial crisis in the propagation of the great depression, American Economic Review 73, 257– 276.

Biais, Bruno, Florian Heider, and Marie Hoerova, 2011, Risk-sharing or risk-taking? counterparty risk, incentives and margins, Working Paper 1571065 SSRN.

Boudt, Kris, Ellen C. S. Paulus, and Dale W. R. Rosenthal, 2011, Funding liquidity, market liquidity and ted spread: A two-regime model, Working Paper 1668635 SSRN.

Brunnermeier, Markus K., and Lasse Heje Pedersen, 2009, Market liquidity and funding liquidity, Review of Financial Studies 22, 2201–2238.

Cifuentes, Rodrigo, Gianluigi Ferrucci, and Hyun Song Shin, 2005, Liquidity risk and contagion, Journal of the European Economic Association 3, 556–566.

Duffie, Darrell, and Haoxiang Zhu, forthcoming, Does a central clearing counterparty reduce counterparty risk?, Review of Asset Pricing Studies

Gai, Prasanna, and Sujit Kapadia, 2010, Contagion in financial networks, Proceedings of the Royal Society A 466, 2401–2423.

Harper, Christine, 2010, Goldman’s pay pool shrinks fastest as traders’ fortunes dwindle, Bloomberg News.

Heider, Florian, Marie Hoerova, and Cornelia Holthausen, 2009, Liquidity hoarding and interbank market spreads: The role of counterparty risk, Discussion Paper 2009-11S European Banking Center.

Huberman, Greg, and Werner Stanzl, 2004, Price manipulation and quasi-arbitrage, Econometrica 74, 1247–1276.

Karatzas, Ioannis, and Steven E. Shreve, 1991, Brownian Motion and Stochastic Calculus (Springer Verlag) second edn.

Lamoureux, Christopher G., and William D. Lastrapes, 1990, Persistence in variance, structural change, and the garch model, Journal of Business and Economic Statistics 8, 225–234.

Melamed, Leo, 2009, For Crying Out Loud (John Wiley and Sons: New York).

Nier, Erlend, Jing Yang, Tanju Yorulmazer, and Amadeo Alentorn, 2007, Network models and financial stability, Journal of Economic Dynamics and Control 31, 2033–2060.

Pesaran, Bahram, and M. Hashem Pesaran, 2010, Conditional volatility and correlations of weekly returns and the var analysis of 2008 stock market crash, Working Paper in Economics 1025 Cambridge University.

Phillips, Matt, 2010, Cds market: Fun facts to drop in cocktail party conversation, Wall Street Journal.

Till, Hilary, 2006, Edhec comments on the amaranth case: Early lessons from the debacle, Working paper EDHEC Risk and Management Research Center.