Risk‐Sharing or Risk‐Taking? Counterparty Risk, Incentives, and Margins

TLDR

Derivatives activity, driven by risk‑sharing, can foster risk‑taking. Central clearing can insure against counterparty risk, provided it preserves risk‑prevention incentives. Bad news about an underlying asset raises protection sellers’ expected liability, weakens their risk‑prevention incentives, limits risk‑sharing, and can trigger contagion, but margin calls after such news can restore incentives and improve risk‑sharing.

Abstract

ABSTRACT Derivatives activity, motivated by risk‐sharing, can breed risk‐taking. Bad news about the risk of an asset underlying a derivative increases protection sellers' expected liability and undermines their risk‐prevention incentives. This limits risk‐sharing, creates endogenous counterparty risk, and can lead to contagion from news about the hedged risk to the balance sheet of protection sellers. Margin calls after bad news can improve protection sellers' incentives and in turn enhance risk‐sharing. Central clearing can provide insurance against counterparty risk but must be designed to preserve risk‐prevention incentives.