Risk-sharing or Risk-taking? Counterparty Risk, Incentives and Margins,”ECB working paper No

Abstract We analyze optimal hedging contracts and show that, although they are designed for risk-sharing, they can breed risk-taking. Bad news about the hedged risk increases the expected liability of the protection seller, undermining her own risk prevention incentives. This limits risk-sharing, creates endogenous counterparty risk and triggers contagion from news about the hedged risk to the balance sheet of the protection seller. Variation margins emerge as an optimal mechanism, which changes risk prevention incentives in addition to providing insurance against counterparty risk. Our theory implies that institutions with stronger asset base and less moral hazard should provide more protection, engage in more risk prevention, and face lower margin requirements. JEL classification: G21, G22, D8