Ulric B. and Evelyn L. Bray Seminar

Over-the-counter (OTC) derivatives markets are very large relative to banks' trading assets, and gross notionals are highly concentrated on the balance sheets of just a few large dealer banks. Moreover, the large volume of varied bilateral trades creates an intricate system of liability linkages between participating banks.  These stylized observations have drawn the attention of policy makers and the public alike. They also clearly illustrate that trading patterns in OTC derivatives markets greatly differ from the Walrasian benchmark of centralized trading at a common price. In this paper, we develop a model of equilibrium entry, trade, and prices, in order to formally analyze positive and normative issues surrounding OTC derivatives markets. Our model illustrates the extent to which standard trading frictions, along with the standard risk sharing motive for trade, lead to a realistic market structure.

Paper can be found at: The Market for OTC Credit Derivatives