Rethink the role of OTC derivatives

Financial Express, 27 September 2008

For many years, turf wars have shaped Indian thinking on the role of privately negotiated (or "OTC") derivatives as opposed to the derivatives transacted transparently on an exchange. The global financial crisis has underlined the importance of using public policy to encourage standardised products to be traded on exchanges. At the same time, there is a legitimate and important role for OTC derivatives in doing customisation.

OTC derivatives

Derivatives trading can be organised in two ways. The first way, which is as old as mankind, consists of private conversations between counterparties. Such transactions are an essential part of economic freedom: Contract law must allow consenting adults to enter into complex contingent claims. This is termed the `over the counter' or `OTC derivatives' business.

Problems with OTC derivatives

There are two classes of problems with OTC derivatives:

  1. Transactions are negotiated privately. There is no guarantee that a trade has been done at the best price. This can be a cover for banks to sell products at unfair prices to customers. Alternatively, there is a possibility of corruption where an employee of a financial firm does a transaction at a wrong price, and gets a bribe in return.
  2. The second problem is that of counterparty risk. An OTC derivatives position is a private contract between two players. When one of them goes bust, the other is left holding a nonperforming contract.

Derivatives markets are very big, with trillions of dollars of positions worldwide. When a firm has very large OTC derivatives positions, this can generate systemic risk. There can be a `domino effect' where the failure of one firm triggers off bankruptcies of others. A few weeks ago, Bear Stearns was a very large player in the OTC market for credit default swaps (CDS) and it was in distress. Putting it into an ordinary bankruptcy process would have generated a disruption for all the counterparties, possibly across the entire CDS market. This motivated an involvement for the US Fed, which gave J P Morgan a short-term line of credit to assist the purchase of Bear Stearns by J P Morgan.

In sum, while derivatives are integral to the modern economy, and OTC derivatives largely play a very useful role, there are some fundamental design flaws in the OTC approach to transactions. The two problems can be addressed by better market design for the class of OTC derivatives where the contract structure is standardised.

Solving these problems

The problem of transparency can be solved by trading on an electronic exchange. Instead of private conversations, all orders would go to exchange screens. The order matching procedure at the computerised exchange guarantees that every order is matched against the best price. It thus ensures sound procurement: the buyer has a guarantee that he is getting a product from the L1 seller. The problems of customer abuse and of corruption are both solved. This is particularly important for PSU financial firms, where the CVC needs to be assured that L1 procurement was done.

The problem of credit risk is solved by a clearing corporation (CC). Once a trade has taken place (whether OTC or on exchange), the CC interposes itself as the legal counterparty to both parties. It does risk management of both exposures. If one party goes bankrupt, the other is not affected. This eliminates the externalities of failure. It makes possible greater creative destruction, because government does not have to come in the way when firms fail.

Both these innovations -- electronic exchange and CC -- are not universally applicable to all OTC derivatives contracts. They are only applicable to standardised contracts, such as the bulk of the forwards and swaps which are now being traded on the Indian currency derivatives market. There is a legitimate role for OTC derivatives in achieving complex contracts (also termed `exotic' derivatives) that are delicately customised to the needs of a client. The architecture here is that financial firms create these complex, customised solutions, and thus add value, while hedging off these exposures using the standardised exchange-traded derivatives.

Indian policy evolution

In the Indian debate, RBI has long emphasised OTC derivatives and tried to prevent the emergence of exchange-traded derivatives. This has been motivated by turf considerations, because exchanges would be regulated by SEBI. The Percy Mistry and Raghuram Rajan reports have emphasised the importance of exchange-traded derivatives, and of the unification of regulatory functions for all organised financial markets (whether OTC or on exchange) at SEBI. The recent events in global finance amplify the importance of exchange-traded derivatives. The credit default swap is a perfectly good product - as long as it is transacted on an exchange with a CC. When transacted OTC, it has helped induce systemic risk.

There is a popular caricature of the Indian financial reforms debate, where it is felt that the traditional RBI positions are about `being safe' while reform proposals are about `risk taking'. Going from sloganeering to gritty detail, we see that a lot of traditional RBI policy positions on finance or macroeconomics are about increasing risk.

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