15 May 2009

Some realism in OTC derivative regulations

The US Treasury has come out with some proposed changes to the world of OTC derivatives. This world of OTC derivatives is a world where two seemingly very sophisticated institutions exchange packages of risks in a customised manner. Over the past year there has been an increasingly loud call to shift these contracts to the exchange space so that there is transparency and honesty in pricing and trading in these securities and there is a central counterparty which guarantees each trade. This is good only in theory.

The size of the market estimated at 680 trillion dollars would require a clearance and settlement system (risk mitigation systems like margining etc) which is simply not practical even within a space of a decade or more. To get a perspective, the GDP of the entire world is around 68 trillion dollars.

Further, however wrong the financial model in the present system, the wrong model would need to be transposed to the exchange space bringing the disaster to the exchange space, and creating a financial disaster which would be far more concentrated than the present crisis. This shift needs to be a lot more thoughtful than is currently being touted by one and all as a cure all panacea.

Other proposals in the papers relating to transparency and suitability are of course eminently doable; the latter is already in place and merely needs to be better enforced.

See news item on Bloomberg.

See the US treasury plan (it's quite brief). 

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