q-fin updates on arXiv.org
Thu, 06 Feb 2020 06:01:19 GMT language
A counterparty credit limit (CCL) is a limit imposed by a financial
institution to cap its maximum possible exposure to a specified counterparty.
Although CCLs are designed to help institutions mitigate counterparty risk by
selective diversification of their exposures, their implementation restricts
the liquidity that institutions can access in an otherwise centralized pool. We
address the question of how this mechanism impacts trade prices and volatility,
both empirically and via a new model of trading with CCLs. We find empirically
that CCLs cause little impact on trade. However, our model highlights that in
extreme situations, CCLs could serve to destabilize prices and thereby
influence systemic risk.