A few buckets of exchange-traded sunshine need to be shed on to the OTC murk, says Greg Newton
Kaffee: "I want free markets."
Col Jessep: [shouting] "You can’t
handle free markets."
(Deliberately misquoted from A Few Good
A funny thing happened on the way to the credit crisis. Back
in the balmy days of September 2005, when credit risk meant not
being levered to the eyeballs, the Federal Reserve Bank of New
York rounded up the usual suspects so that its then largely
invisible president, Timothy F Geithner, could administer a
stern thrashing along the general theme of somebody needs to
get a handle on the credit derivatives paper chase.
The meeting went very well. Yes, the usual suspects said, we
understand your concerns. No, it’s not our fault.
It is those damned hedge funds, but we are the grown-ups of the
global financial system, and we will fix it. And they did.
No, really: just follow the press releases. On March 13
2006, New York Fed Welcomes New Industry Commitments on Credit
Derivatives; November 21 2006, New York Fed Welcomes Industry
Commitments on Equity Derivatives; on May 15 2007, New York Fed
Welcomes New Commitments on Equity Derivatives; then on October
24 2007, it was New York Fed Welcomes Equity Derivative Client
On-boarding Strategy; and, on March 27 2008, not two weeks
after Bear Stearns was gift-wrapped into the highly
incentivized arms of JP Morgan Chase, the headline was New York
Fed Welcomes New Industry Commitments on Credit
So, on June 9 2008, not quite three years after that first
meeting, the Federal Reserve Bank of New York again rounded up
the usual suspects and administered a stern thrashing along the
general theme of: somebody needs to get a handle on the credit
derivatives paper chase.
To be fair, some progress was made in the interim. According
to the New York Fed, 91% of credit derivatives trades are now
confirmed on electronic platforms. The number of trade
confirmations outstanding by more than 30 days has dropped by
86%, although that number is nowhere near as impressive as it
sounds given the still explosive growth in the underlying
Its proposed solutions to these challenges draw extensively
on the exchange-traded derivatives markets model. More
standardized contracts, and automated trade processing; a
central clearing house, to reduce the systemic risk of a
counterparty failure (see Bear Stearns); a standard procedure
for sorting out credit events; and "extending infrastructure
improvements to OTC equity, interest rate, foreign exchange and
Which is a good start, but goes nowhere near far enough in a
world where the OTC derivatives tail – $596 trillion
in outstanding contracts at the end of 2007, more than eight
times that of all exchange-traded financial contracts
worldwide, according to the Bank for International Settlements
– is pretty much wagging the cash market dog, whether
credit, equity, interest rate, FX or commodity.
The dubious pronouncement by the OTC gang is that the
business should remain unregulated because its products are
always subject to negotiation between the parties.
In the real world, of course, the impact of these deals is
felt in public markets of all kinds, not least through the
hedging activity of the dealers as they trade around their swap
exposures. Also, a growing pile of evidence suggests that the
bunnies with good noses – exponents of what the
UK’s Financial Services Authority calls "informed
trading" – have moved their preferred playground from
the regulated options markets, which have been known to drop a
dime on fortuitously timed trades, to credit default swaps.
The single most important word missing from the New York
Fed’s imprecations is transparency. On any given
day, anybody who cares can click on the website of their choice
and find, for free, the latest price and volume statistics for
the exchange-traded instrument of their choice, whether it is a
single stock, a government bond, or 37,500lbs of Arabica
By contrast, and by clear design intended to maintain the
house’s advantage, nobody has any kind of handle
on what is going on in the OTC markets. All we know is that
they are growing explosively and, on any given day, exactly who
is on at least one side of a material proportion of its
transactions is something of a mystery.
Those uncertainties have already played a major role in the
destruction of one major financial institution this year, and
more will certainly follow unless a few buckets of sunlight are
thrown on to the OTC murk.
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