Managing Counterparty Risk in OTC Markets

Abstract

We study how banks manage their default risk to optimally negotiate quantities and prices of contracts in over-the-counter markets. We show that costly actions exerted by banks to reduce their default probabilities are inefficient. Negative externalities due to counterparty concentration may lead banks to reduce their default probabilities even below the social optimum. The model provides new implications which are supported by empirical evidence: (i) intermediation is done by low-risk banks with medium initial exposure; (ii) the risk-sharing capacity of the market is impaired, even when the trade size limit is not binding; and (iii) intermediaries play the fundamental role of diversifying the idiosyncratic risk in CDS contracts, besides increasing the risk-sharing capacity of the market.