Otc derivatives trading platforms
Also, there is a danger that the new rules will hinder financial innovation by dealers. It gives regulators the opportunity to recognize situations where unacceptable risks are being taken. It also creates more post-trade price transparency. Trade repositories are to some extent still a work in progress, but we seem to be heading in the right direction.
No doubt politicians and regulators were greatly influenced by the AIG fiasco. AIG Financial Products entered into many transactions where it guaranteed the AAA-rated securities created from the securitization and re-securitization of subprime mortgages.
Only then did regulators become aware of the risks that had been taken. A massive bailout followed. A situation similar to AIG should never happen again. First, trade repositories would allow regulators to be more aware of the one-sided risks being taken, making it possible for them to step in earlier. Second, a company entering into trades similar to those of AIG would be required to post so much initial margin and variation margin that its appetite for the trades would be greatly diminished.
CCPs now play a key role in derivatives markets. A sure sign of this is that a very popular topic of conversation in the OTC derivatives markets has been the basis spread for interest rate swaps between the two largest CCPs: Clearnet and CME Group. On a particular day, the year U. Both CCPs mark trades to market in a way that reflects the terms of the deals they are currently clearing.
The reason for the discrepancy is that the CME Group tends to clear trades between dealers and end users, such as asset managers, and these end users currently want to pay fixed; LCH. Clearnet tends to clear trades between dealers. The above quotes suggest that end users pay two basis points more than dealers on average. A dealer that receives 2. Of course, the profit will be realized over the ten-year period. But it is possible that trade repositories can help CCPs avoid this sort of market segmentation.
This would allow the CCPs to base their marks on all transactions being currently initiated, rather than just the flow of transactions that they themselves see. The least important, and least defensible, of the new regulations for OTC derivatives is the requirement that standard transactions between financial institutions be traded on electronic platforms.
The motivation for this seems to be that, if OTC derivatives are traded like exchange-traded derivatives, there will be more price transparency and problems such as those observed during the crisis will be avoided.
In fact, the problems during the crisis were caused by non-standard derivatives and there is no requirement that these be traded on electronic platforms. There was not a serious problem in the way OTC derivatives were traded pre-crisis. Arguably there may not have been enough price transparency, but this is not clear. The regulators were probably not aware of the pricing issues but the industry participants probably understood things pretty well.
At any rate, trade repositories should take care of any transparency issues. As a result, trading OTC derivatives in the same way as exchange traded derivatives is not necessary to achieve price transparency. In addition, there is a danger in trying to trade OTC derivatives in the same way as exchange-traded derivatives. This is because, as pointed out by Giancarlo , there are important differences between the two. OTC derivatives trade intermittently whereas exchange-traded derivatives such as futures trade continuously.
The size of a typical OTC derivative is much larger than that of a typical exchange-traded derivative. There are fewer market participants in the OTC market, but they are more sophisticated than the average participant in exchange-traded markets.
These differences mean that we should not force standard OTC derivatives to trade in a similar way to futures and other exchange-traded derivatives. No doubt electronic platforms will play a bigger role in the trading of OTC derivatives as time passes, but we should let the market decide the best way to organize trading.
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