15 Apr 2010

Shaping Reforms and Business Models for the OTC Derivatives Market

Quo vadis?

Diego Valiante

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Now that the worst of the financial storm is over, regulators are setting new strategies to deal with the systemic importance of the €427 trillion ($604 trillion) over-the-counter (OTC) derivatives market. This paper explores the three major sources of disruptive effects in OTC derivatives: liquidity, counterparty risk and legal uncertainty. These risks affect the value chain of a typical derivative transaction and weaken the economic and legal rationale behind their widespread use. On the policy side, commitments have been made at G-20 level to draft uniform rules on a global scale “to build a safer financial system”. This paper finds, however, that in practice, the EU and US proposals lay out divergent roads to meet common objectives and the author warns that such divergences may encourage regulatory and supervisory arbitrage. Policy options currently under discussion may need further revision. For instance, access to network clearing infrastructures, such as CCPs, can only be made available to a restricted group of eligible derivative products. Mechanisms of adverse selection and moral hazard, then, may at any time affect the efficient functioning of these crucial infrastructures for financial markets.

Diego Valiante is a researcher at the European Capital Markets Institute and the Centre for European Policy Studies.

Keywords: OTC derivatives, central counterparty clearing (CCP), data repositories, collateral management, electronic trading platform, exchange, market transparency, systemic risk , financial and securities regulation, corporate finance, capital markets, financial crisis