Dealers’ insurance, market structure, and liquidity
Many financial markets operate through dealers, market-makers, or similar intermediaries that promote liquidity in over-the-counter (OTC) markets. Following the Great Financial Crisis of 2007-09, clearing of standard derivatives contracts through a central counterparty (CCP) became mandatory. Through novation, CCP clearing reduces counterparty risk and reinforces market liquidity and stability. However, the effects of these reforms on the structure of the markets in which they are implemented have been little studied.
We analyse the effects of introducing measures aimed at reducing counterparty risk on dealers’ entry/exit, the market share of each dealer, liquidity measured by bid-ask spreads, and the overall welfare of dealers and end users in normal times. Also, we analyse the impact of adopting these measures on the incentives of dealers to innovate in better market-making technologies.
One may expect that initiatives aimed at reducing counterparty risk would bring uncontested benefits. In line with the theory of the second best, we show that such initiatives could to some extent “backfire” – for example, dealers can have too little incentives to innovate in more efficient market-making activities. The reason is intuitive: reducing counterparty risk for all lowers cost and opens up entry to less efficient dealers. More entry improves liquidity by reducing the bid-ask spread. However, this lowers rents, thus reducing the incentives of dealers to innovate in the first place. Welfare could decrease. When accounting for the desirability of CCP clearing, its benefits for the financial system should compensate for the loss of efficiency due to, for example, a lack of innovation.