Regulation of OTC Derivatives

Last month, the UK Financial Services Authority (FSA) and the Treasury put out a document entitled “Reforming OTC Derivative Markets: A UK perspective.” My one line summary of this document is that the UK does not wish to make any significant changes to the regulations of the OTC markets. A cynic would say that this is explained by the fact that London dominates the OTC derivative markets globally.

This month there was a nice paper by Darrell Duffie and two co-authors for the New York Fed advocating not just central clearing, but also encouraging the use of exchanges and electronic trading platforms, as well as post-trade price transparency. I like this report though the Streetwise Professor thinks that this is tantamount to socialist planning.

Streetwise Professor has been arguing in a series of posts on his blog that OTC markets have evolved naturally and must therefore represent an efficient outcome absent demonstrable externalities. This argument deserves serious consideration and is one to which I am sympathetic.

One of the early and clear enunciations of the private ordering argument is a paper over ten years ago by Randall Kroszner (“Can the Financial Markets Privately Regulate Risk?,” Journal of Money, Credit & Banking, 1999) which describes the historical evolution of exchange clearing in the last century and compares it to the development of the OTC markets. As I re-read this paper, I was struck by two statements in the paper.

• Kroszner argues that the large derivative dealer “effectively creates its own ‘mini’ derivatives exchange, with its own netting, clearing, and settlement system.” with the International Swap Dealers Association (ISDA) providing partial standardization of contractual terms.
• Kroszner also points out that: “Credit rating agencies are the effective regulators in setting standards for capital, collateral, and conduct, much like clearinghouses and government regulators, but do not have a direct financial stake in the transactions.”

This analysis provides one perspective on what went wrong during the crisis. First, the “regulation” provided by the rating agencies was an absolute disaster and the “mini derivatives exchange” run by the large derivative dealers turned out to be far less robust than the derivative exchanges.

At the same time, private parties have no incentive to move from the failed model to the robust model because the failed model now comes with the wrapper of a “Too Lehman-like To Fail” guarantee from the government. In the absence of this government guarantee, private ordering might have been relied on to do the right thing, but in its presence, things are different.

Posted at 2:45 pm IST on Tue, 12 Jan 2010         permanent link

Categories: derivatives, exchanges, regulation

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