Transitive Counterparty Risk and Financial Contracts

This article develops a new theory of interconnected financial contracts. It focuses on a common type of interconnected contracting scenario, in which party A enters into a contract with B, and B enters into a separate contract with C. While A and C are not in privity of contract, their common relationship with B exposes them to “transitive counterparty risk.” Party B, in short, is a conduit which transmits risk. If C enters into a contract with D, both A and B are exposed to potential transitive risk, and so on. There are at least four reasons why it is important to develop a better understanding of transitive risk contract relationships. First, the most basic type of transaction involving financial institutions - in which the institution acts as a financial intermediary - creates a transitive risk relationship. For example, the relationships among bank depositors, between depositors and bank borrowers, and between depositors, borrowers, and the FDIC all involve transitive risk contracts, in which the bank acts as a conduit. Second, transactions in financial markets often involve transitive risk contracts: derivative transactions, repos, and the securitization process all involve transitive risk relationships. Third, even a relatively simple financial contract can nonetheless have a high degree of complexity, if it is part of a larger chain of transitive risk contracts. Fourth, parties must account for transitive counterparty risk in order to price financial contracts, and regulators charged with implementing the Dodd-Frank Act must account for counterparty risk in order to determine whether or not financial institutions are too interconnected or the proliferation of a particular type of contract threatens the financial stability of the United States