Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

More on OTC derivatives

I have several comments by email on my blog post
yesterday on OTC derivatives. This post responds to some of them and
adds some more material on the subject.

One of the papers that I did not refer to in yesterday’s post
was a paper by Riva and White on the evolution of the clearing house
model for account period settlement at the Paris Bourse during the
nineteenth century. Streetwise Professor linked to a conference
version of this in his post while Ajay Shah
pointed me to an NBER version
of the same paper.

The account period settlement at the Paris Bourse was similar to the
‘badla’ system that prevailed in India until the beginning of this
century. All trades during a month were settled at the end of the
month so that the stock market at the beginning of the month was
actually a one month forward market. At the end of the month, the
settlement could be postponed for another month on paying the price
difference and a market determined backwardation or contango charge.
In fact, this system for trading individual stocks continued even
after the introduction of stock index futures (CAC 40) in the Paris
market. Crouhy and Galai, “The settlement day effect in the
French Bourse,” (Journal of Financial Services
1992) provide a good description of this market and
explore the working of the cost of carry model in this market.

Coming back to Riva and White, they document the emergence of a
clearing house model in which the Paris Bourse guaranteed all trades
on the exchange. The bourse not only guaranteed settlement of trades
between two brokers but also repaid the losses suffered by the
defaulting broker’s clients (except during a period from 1882 to
1895). This clearing house guarantee was supported by a capital
requirement for all brokers and by a guarantee fund, but not by any
margins. The entire process seems to have been driven by the
government and the central bank.

By contrast, the US futures exchanges introduced initial and
variation margins well before they introduced the clearinghouse in
1883 as documented in the Kroszner paper that I mentioned in my post
yesterday. The existence of margins eliminates most of the moral
hazard problems that plagued the clearing house in Paris and required
state intervention of some form or the other. The US thus saw a
private ordering emerging without any involvement of the state.

India ran the ‘badla’ system in the nineteenth and
through most of the twentieth century without any margins and without
any clearinghouse guarantee. While France solved the risk problem in
its usual dirigiste style and the US solved it using private ordering,
India seems to be a case of state failure and market failure until the
last decade of the twentieth century. In fact, the problem was solved
only a few years before the abolition of ‘badla’

Now I turn to some other papers relevant to the regulation of OTC

Viral Acharya and several coauthors have written extensively on the
regulation of OTC derivatives, and I will mention two. Acharya and
Engle have a nice paper that
explains the key issues in the context of the proposed US

Acharya and Binsin have a conference
explaining how an exchange is able to price counterparty
risk better than the OTC market because it is able to see the entire
portfolio of the counterparty. Streetwise Professor
criticizes this on the ground that exchanges charge the same price to
everybody and do not discriminate. I think this criticism is incorrect
– exchanges do not discriminate in the sense that they apply the
same risk model to everybody, but the standard SPAN type model is a
portfolio model where the margin is not on an individual position but
on a portfolio. The incremental margin requirement for any position
thus depends on what else is there in the portfolio. Thus the risk is
priced differentially.

The Acharya and Binsin paper must be read in conjunction with a paper by Duffie and Zhu
who show that the efficiency gain from central clearing is best
realized when there is a single clearing house for all derivatives and
the gains may disappear if there are separate clearing houses for
different products and even more so when there are competing clearing
houses for the same product. This in my view is only an efficiency
issue and does not detract from the reduction of systemic risk from
the use of central clearing.

For those interested in data about the magnitudes involved in these
markets in terms of risk and collateral requirements, a good source is
an IMF
Working Paper
on “Counterparty Risk, Impact on Collateral
Flows, and Role for Central Counterparties.” For more detailed
information about the CDS market, there is an ECB
on “Credit default swaps and counterparty risk”


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