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A blog on financial markets and their regulation
Dr. David Murphy of the Deus ex Machiatto blog has published a comprehensive book on clearing of OTC derivatives (OTC Derivatives, Bilateral Trading and Central Clearing, Palgrave Macmillan, 2013). I was surprised that the author information on the book cover flap does not mention the blog at all but gives prominence to his having been head of risk at ISDA. Had I found this book at a book shop, the ISDA connection might have made me less likely to buy the book because of the obvious bias that the position entails. This was a book that I read only because of my respect for the blogger. Many publishers have obviously not received the memo on how the internet changes everything.
The book presents a balanced discussion of most issues while of course leaning towards the ISDA view of things. Many of the arguments in the book against the clearing mandate would be familiar to those who read the Streetwise Professor blog. Yet, I found the book quite informative and enjoyable.
In Figure 10.1 (page 261), Murphy summarizes the winners and losers from the clearing reforms. To summarize that highly interesting summary:
Obviously, the clearing mandate has not quite worked out the way its advocates expected. Clearing was originally expected to lead to greater competition and reduce the dominance of the big (G14) dealers. Murphy explains that the big dealers will actually benefit from the mandate as they can more easily cope with the compliance costs.
I am not disturbed to find corporate end users listed as losers. If Too Big to Fail (TBTF) banks were being subsidized by the taxpayer to write complex customized derivatives, these products would clearly have been under priced and over produced. When the subsidy is removed, supply will drop and prices will rise. This is a feature and not a bug.
If the price rises sufficiently, end users may shift to more standardized and simpler products. Of course, this will imply basis risks because the hedge no longer matches the exposure exactly. This matters less than one might think. The Modigliani Miller (MM) argument applied to hedging (which is actually very similar to a capital structure decision) implies that most hedging decisions are irrelevant. The only relevant hedging decisions are the ones that involve risks large enough to threaten bankruptcy or financial distress and therefore invalidate the MM assumptions. Basis risks are small enough to allow the MM arguments to be applied. Inability to hedge them has zero real costs for the corporate end user and for society as a whole.
One could visualize many ways in which the market may evolve:
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