Eliminating OTC Trading Could Be A Disaster

The financial crisis has a prompted an unhealthy fetish for transparency, though we have no idea what that actually means. Do politicians want banks to produce a big .xls file of all of their transactions and assets that anyone can download?

Anyway, one, ahem, modest proposal, has been to move some or all OTC derivative trading onto some unified electronic exchange. We’re tempted to say that at this point, this is akin to closing the bar door after the horse has left, except that, well, um, it’s not at all obvious that OTC-traded instruments are the horse. Of all the fires we’re putting out, the actual mechanics of derivatives trading hasn’t been much of an issue.

The Streetwise Professor blog makes a strong argument why forcing derivatives onto an exchange could be a disaster. The basic idea: derivatives aren’t necessarily fungible. An AIG credit default swap written by Citi and Berkshire probably shouldn’t trade for the same amount, given the disparity in counterparty risk:

Market participants and the instruments they trade are heterogeneous.  This heterogeneity can–and almost certainly does–make it efficient for multiple, differentiated trading platforms to exist side-by-side.  Heck, even the most homogeneous of financial instruments–the stock in a particular company–trade on different types of trading mechanisms in order to meet the diverse needs and preferences of investors with different information and preferences regarding the rapidity with which they want to trade.  Closely related instruments can trade on a variety of platforms.  For instance, cash Treasuries and Treasury futures trade using very different mechanisms.  In a nutshell, it is desirable to allow the development of a variety of different trading mechanisms (microstructures) to permit a discriminating match between the characteristics of the mechanism and the characteristics of the instruments and their traders.

Forcing a one-size-fits-all trading approach completely ignores this heterogeneity.   It will impose costs on market users, and may even serve to undermine their soundness and integrity.

I’ve argued repeatedly that with respect to clearing (i.e., default risk sharing) in particular, there is a strong case to be made that some instruments should be centrally cleared–but some should not.  Central clearing provides benefits, but it comes with costs due to asymmetric information.  Indeed, since market participants internalize most of the benefits from clearing, they have a strong incentive to adopt it unless there are even larger costs.

With respect to the soundness of the financial system, forcing central clearing can increase systemic risk.  Clearinghouses don’t price dealer balance sheet risk–dealer counterparties in bilateral OTC markets do.  Dealers typically have better information about the creditworthiness of their counterparties than a clearinghouse will.  Thus, they can price default risk more accurately.  Clearinghouses treat all members as if they are the same–even though they are not, having different balance sheet risks, for instance.  This equal treatment of the unequal tends to divert trading activity towards riskier firms more likely to default.  Reductions in collateralization reduce trading costs and encourage an expansion of trading activity.  At best, clearing redistributes the default losses, and this redistribution (away from derivatives counterparties to dealers’ other creditors) can exacerbate, rather than reduce systemic risks.

Btw, the inciting event here? Sen. Harkin has actually threatened/promised to make all trading exchange trading.

(via Knowledge Problem)

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