Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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3 responses to “Regulation of OTC Derivatives

  1. Ted K January 12, 2010 at 10:16 pm

    This is a terrific post Professor Varma. I plan to link to it on my site today, with a small amount of my own commentary (I am very very much in favor of Registered Exchanges). If you have time please post more on this topic, Registered Exchanges vs. Clearinghouses. I feel this topic will increase in importance over time, especially after the next crisis.

    Please continue your terrific work and posts.

  2. Prof. Jayanth R Varma January 13, 2010 at 8:23 pm

    Thanks. I have posted again on the same topic.

  3. financialspreadbetting May 31, 2010 at 3:08 pm

    The UK are in a tough position. They are so reliant on the bank sector. More regulation although good in the long term might scare off banks from the UK in the short run. Britain may be fuelling a further crisis to come.

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