Competition in regulated over-the-counter markets

Abstract

A common thread throughout all three thesis chapters is the combined usage of theoretical models and empirical methods to study the effect of a regulatory shift on the (competitive) equilibrium outcomes. In the first chapter, I analyze the effect of mandatory counterparty default insurance (central clearing) of over-the-counter (OTC) derivatives on aggregate financial risk exposure. I carefully model the competitive mechanisms in both the OTC derivatives and their insurance market. I show that the introduction of mandatory insurance empowers the for-profit central counterparty (CCP) to raise prices, wherefore only larger clients opt to additionally insure their derivatives (lower credit risk). Smaller clients instead exit the market and remain unhedged (higher market risk). I conclude with a model calibration and counterfactual policy evaluation for the EuroDollar FX derivatives market, showing that mandatory insurance increases aggregate financial risk. In the second chapter, joined with Iman van Lelyveld and Ellen van der Woerd, we predict the reduction in short-sell constraints due to an out-ruling of exclusive security lending agreements (ESLAs). Broker-dealers intermediate stock lending between lenders with large portfolios and borrowers seeking to short sell. We study why some lenders commit to a single broker-dealer via exclusive security lending agreements (ESLAs) at the cost of foregoing profitable trades, and how this impacts aggregate lending. We provide a detailed market overview both on a transaction and counterparty-pair level. Gained insights inform a three-period representative lender model that rationalizes why ESLAs arise in equilibrium. After carefully evaluating the model fit, we predict the counterfactual trading volumes in the absence of existing ESLAs. We find that trading volumes would significantly increase, up to 8%. In my final chapter, joined with Johannes Fischer, we study the impact of stress tests and complementary dividend regulations on equilibrium bank lending. Bank stress tests, regularly conducted to ensure stable lending, constitute a de facto constraint on balance sheets: equity must be sufficient to maintain current lending also in the future, even after absorbing severe loan losses. We study the effects of such forward looking constraints in a representative bank model. More severe-stress test scenarios lead to lower dividends, higher equity levels, and universally lower, albeit less volatile, lending. We calibrate our model to large U.S. banks, subject to Federal Reserve stress tests, and compute the optimal, state-dependent severity of stress tests and implied capital buffers (up to 6% during normal times). Finally, we complement stress tests with three macroprudential policies: the Covid-19 dividend ban, the counter-cyclical capital buffer (CCyB), and the proposed dividend prudential target (DPT). We find that combing stress tests with a dividend ban or DPT improves supervisor welfare equally. Due to its discontinuous nature, however, relaxing the CCyB falls short.