As I am trying to communicate from my last post that the market for OTC derivatives is mammoth in size.  I tweeted few days back that Dodd-frank act will take 24 million man hours per year to comply with. It took 20 million man hours to build Panama Canal!! .I have tried to put my views in my past articles over OTC.Derivatives Central Clearning & Dodd – Frank .Central Clearning Of derivatives & Dodd – Frank continues… , Credit derivatives Cat bonds & Cat Swaps ,OTC derivative series CDS, Bonds and Basis Trade

I got the opportunity to read one of the recent paper on Reforming the OTC derivatives market by William C Dudley .

Dudley believes the pre-crisis OTC derivatives market needed reform. Let’e examine his case.During the crisis collateral calls generated by sharp movements in the mark-to-market value of the OTC derivative trades drained liquidity buffers and provoked the fire sales of assets. These fire sales increased volatility and provoked still greater margin calls.
Yes, but nothing proposed since would ameliorate this. The trades concerned would not have been clearable (no one is proposing clearing CDS on ABS), and indeed the introduction of clearing is making margin-driven liquidity risk worse not better.

The bilateral nature of the OTC derivatives market – between the two parties to the contract – be it dealer and customer or dealer and dealer – created its own set of difficulties. When counterparties became concerned about the health of a particular dealer, they often moved their trades – via novation – to other dealers. They did this to protect themselves should the dealer subsequently fail. But this process was difficult to carry out quickly and in size. The cumbersome nature of the process disturbed market liquidity and function. It also tended to drain off the liquidity from the troubled dealers because these dealers often used the counterparty cash collateral to fund their own operations. When customers moved their business, the collateral balances departed with them and this worsened the funding crunch on the troubled dealers.
This is fair, but notice that to fix this, we don’t need central counterparties; we just need a more efficient way to do novation.

when a large counterparty, Lehman Brothers, filed for bankruptcy, it could no longer meet its obligations. The claims of Lehman’s customers, including those open OTC derivatives positions in which Lehman owed them money, were frozen. The lack of adequate segregation of the customers’ assets from the Lehman estate and the inability to move the outstanding obligations to other dealers – which we refer to as the lack of portability – created large problems for Lehman’s counterparties. Often Lehman’s clients were in the position that one side of a trade executed with Lehman was frozen, but the offsetting side remained open and exposed to volatile financial markets. This asymmetry contributed to the sharp increase in market volatility, the dramatic reduction in market liquidity, and the impairment in market function following the Lehman failure.

OK, so this is a motivation for clearing. But you could do a lot to help this problem by (a) building continuity of derivatives into the resolution regime for large financials (as, typically, is happening), (b) fixing the unenforced mess that are the segregation rules (cf. MF global) and (c) slowly – and carefully – moving away from collateral rehypothecation.

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