Exchange Traded and Cleared vs Bilateral OTC – is it really so black and white?

As the trauma of the financial crisis turns to analysis and proposals to prevent it happening again, we hear much about law makers’ and regulators’ desire to see the OTC derivatives markets tamed.

It is clear to everyone that the exchange traded derivatives markets, with their associated central clearing and settlement mechanisms, fared well in the crisis.  The smooth unwinding of Lehman Brothers’ positions held by the clearing houses appears to have been a model of how a major default should be handled.

It is not surprising therefore that regulators have looked at the considerably less satisfactory situation in sections of the OTC derivatives markets and decided that central counterparty clearing is the solution.  It has a number of attractions for regulators:

  • Multi-lateral netting to net exposures across the whole market
  • Standardised risk management processes
  • Standardised, transparent settlement and mark to market pricing
  • Full collateralisation of risks
  • Information on the positions and risks of individual players available to regulators
  • Efficient centralised administration

But it is not so simple to push some OTC contracts into clearing, as can be judged from the difference of opinion between clearing houses on the extent to which single name CDS can be cleared without systemic risks.

For some contracts it can be difficult to get reliable mark to market and settlement prices.  In some markets, in which prices significantly reflect the credit of the counterparties, the introduction of a clearing central counterparty can “even up the playing field” in a way which penalises the most creditworthy players.

Reading most of the public discourse on this subject gives the impression that there are only two choices – either OTC with administration carried out bilaterally between the trading parties or clearing through a multilateral netting central counterparty.  But are the choices really that stark?  Are there not additional solutions which would go a long way towards meeting the regulators ultimate objectives but also allow a wider range of OTC contracts to be included?

A centrally administered bilateral clearing arrangement could be such a solution.  It could have:

  • Bilateral netting to net exposures between any pair of counterparties
  • Standardised risk management processes
  • Settlement and mark to market pricing which would be agreed between the parties but regulated
  • Full collateralisation of risks
  • Information on the positions and risks of individual players available to regulators
  • Efficient centralised administration

It would have many of the benefits of a multi-lateral clearing arrangement, the differences lying in the method of mark to market and settlement pricing and that a central counterparty is not involved.  It could, however, be able to accommodate a wider group of OTC contracts than the conventional clearing arrangement.

With more flexible thinking from both regulators and clearing houses it may be possible to apply many of the very positive aspects of centralised clearing to a bigger proportion the OTC derivatives business.

A one-size-fits–all, multilateral netting, clearing solution does not have to be the only alternative to the current methods of administering OTC derivatives trades.

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