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Home > Blogs > Anthony Harrington > The new emerging structure for derivatives

The new emerging structure for derivatives

Finance Blogger: Anthony Harrington Anthony Harrington

At the end of April, Deutsche Bank Research (DBR) released its briefing paper on OTC derivatives [PDF, 315 KB]. Without doubt, this is a market that in many ways holds the future health and wellbeing of the global financial system in its shadowy hands. At the peak of the derivatives market, before the crash, gross notional amounts outstanding for over-the-counter (OTC) derivatives amounted to £605 trillion, according to DBR. That is a very big number, and it matters because the global financial meltdown revealed a number of what DBR calmly calls “structural deficiencies” in the OTC market infrastructure.

Undoubtedly the biggest of these was the lack of any formal way of managing, or even understanding, counterparty risk. There was simply no one publicly available place, or even three or four places, that you could go to and read off the total gross exposure of a particular company with any certainty. With the way derivatives are often further sliced and diced and sold on, the risk of contagion spreading through the financial system was huge.

It wasn’t always like that. In a proper, bilateral derivatives contract, what transpires might be private between the parties involved, and thus completely opaque to anyone not party to the transaction, but the risk involved was almost always fully collateralized. However, as DBR notes, as things got more complicated the market became accustomed to "asynchronous collateral cycles" and just how trades were being collateralized between multiple parties became more and more opaque, resulting in uncollateralized exposures ramifying and multiplying.

The fastest way of reforming the OTC market, and the way that a number of politicians in both Europe and the US have seized upon, is to force as much of the OTC derivatives trade as possible to go through central counterparty clearing (CCP). The beauty of the CCP approach is that the CCP acts as the seller to any buyer and the buyer to any seller. They are market-led organizations, by and large, and are funded by the market, which gives them pretty deep pockets. No one has pockets that are $605 trillion deep, of course, but the global pool of derivatives does not all turn to mist in the hand simultaneously, so, the argument goes, no one’s pocket has to be deep enough to cover the entire derivatives market.

The problem in implementing this change to the derivatives market is not finding CCPs. There are plenty of organizations throwing their hats into the ring. The problem is that the CCP model is not well suited, as it stands, to handle the more complex, bespoke varieties of derivates. The derivatives market, as DBR notes, is a hugely dynamic market. A good part of it is about risk mitigation (hedging) and the other part is about speculation.

Cue a politician with the word “speculator” and they’ll come up with some synonym for “evil bastard,” but speculation is a vital source of liquidity to markets. If you are a business wanting to cap the price of fuel oil six months hence, you have to find someone willing to take the other side of the trade. The bank does that but the bank will usually want to lay that bet off to someone else. If there is no business to stand up and take the other side of the trade, someone taking a punt will do just as nicely. When regulators go clumping about with heavy boots in this kind of process, they run the risk, as DBR puts it, of hampering “the viability and innovative powers” of the derivatives market.

Again, this is a saga that is going to run and run over the coming year or two. Watch this space…

Further reading on derivatives

Tags: central counterparty , derivatives , economic recovery , GDP growth , regulation , transparency
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