20 June 2009

OTC derivatives - US is too impractical

I wrote a piece for the Economic Times last week on the US Treasury plan on OTC derivatives, which I think is overly ambitious. Here is the piece:

"AFTER hearing a year’s worth of regulatory chest thumping — of attempting to regulate the exotic world of over the counter (OTC) derivatives — some realism seems to have seeped into the US government thought process, though not fully. The US treasury has just now come out with a short proposal to tame and confine the wild animal. The issue is that much of the issue and trading of OTC derivative securities is carried out in an opaque and bilateral world. This is a world where two seemingly very sophisticated institutions exchange packages of risks in a customised manner.

The OTC derivatives markets have rightly and wrongly been blamed for the current financial market crisis where these instruments all blew up at the same time because of the so called sophisticated financial models which were used to price them and measure how risky they were - individually and collectively. 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 counter-party which guarantees each trade. This sounds good except for two major fallacies.

First, the nature of the instruments (though in a minority of cases) is such that many of them can never be traded on an exchange — simply because each contract is unique and customised to suit the other party’s need for risk mitigation. To be fair, the treasury plan does not attempt to move these out of the OTC’s bilateral space and correctly recognizes that a market with small number of players doing larger deals (even in India the standard size for a one year overnight index swap is Rs 100 crore) is different from a market with a large number of players doing small deals. Second, moving a market estimated at $680 trillion to a central clearance and settlement system (with risk mitigation systems like margining etc) 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. Further, however wrong the financial model in the present system, the wrong model would need to be transposed to the exchange space with whatever stated improvements - for calculating margins etc. Even if such a migration was possible by regulatory edict, this could create a financial disaster which would be concentrated (in one exchange) as opposed to the diffused crisis (among many participants) we are seeing today. This shift needs to be a lot more thoughtful than is currently being touted by one and all as a cure all panacea. Assuming we can use the equity market risk mitigation systems in these complex instruments may lead us to further false comfort.

The push to send trades over to the exchanges and electronic platforms with risk mitigating systems (like margining of trades and counter party guarantees) is unlikely to be very successful even in the medium to long term given the sheer size of the market and also the size of each trade.

It seems the realisation has partly dawned on the US government and regulators and after the initial rhetoric a more sensible approach is now proposed . The same proposal also recommends a reporting system of these instruments with respect to their issue and trading, thus creating a higher level of transparency in the market resulting in potential improved understanding of the systemic impact of the risk. A similar attempt at creating transparency in the bond market resulted in substantial increases in transparency and reduction in the price of the buy-sell rates (known as the bid-ask spread in market jargon) of corporate bonds in the US some 7 years back. India also similarly implemented a compulsory reporting system in the corporate bond market in 2007 with good effects.

The proposal may be too ambitious, except in its transparency initiative and it would be worthwhile to look at its success before attempting to replicate it in India."

No comments: