standard (i.e., exchange-traded) vs. OTC derivatives: what the issues are

The financial crisis and OTC derivatives

During the financial crisis, the world found out that many of the “toxic assets” held by commercial and investment banks were OTC (over-the-counter) derivatives.  Worse than that, the holders were unable to say with any degree of certainty how much they potentially owed or to whom.  Even more distressing, the CEOs of the banks appeared to be unaware that they held these things or what the problems with them might be.  This came in spite of what was supposed to be a clean-up of derivative documentation forced by the Fed several years earlier.  As a result of this stunning negligence, during the crisis the authorities were working pretty much in the dark when they were trying to come to grips with the extent of the toxic derivative problem.

Congress is now in the process of crafting regulations about derivatives to try to prevent the country from getting into a similar mess in the future.  The simplest, and most extreme, proposal is to in effect ban OTC derivatives and force all derivative contracts to be standardized and all trading to take place on formal exchanges.  The idea is being opposed by bank lobbyists as well as by some corporate customers.  What are the issues?

What  OTC and exchange-traded derivatives are:

Exhcange-traded

The options market or any of the commodities exchanges are examples of how a standard or exchange-traded derivatives market works.  Central to its operation is a clearinghouse or exchange, which has three main functions.  It:

1. sets the characteristics of the instruments traded:  size of contract, settlement dates, manner of settlement and pricing.  No deviation from the rules specified by the exchange is allowed.

2. keeps track of all the contracts outstanding, so that it knows the daily details of who owes what to whom, and the world at large knows the aggregate information about each type of contract.

3.  sets and enforces margin requirements, to ensure that no parties default on their obligations.  This involves daily pricing of all contracts and settlement of any resulting requirements for additional margin.  Margin money consists of cash or liquid securities that can be sold, if need be, to cover losses on the derivative contracts held.

OTC

OTC derivatives, on the other hand, are private contracts between two parties, typically either between the proprietary trading desks of two banks or between a bank and one of its customers.  The attributes of an OTC derivative are:

flexible structure as to the object being speculated in/hedged and the length of the contract.  In the equity arena, for example, it was very common at one time for foreigners to use OTC derivatives to circumvent local regulations that made it difficult for foreigners to buy stocks in India or Taiwan.

no margin requirements.  The bank writing the OTC derivative might (or might not) require its counterparty to provide collateral to protect against default.  But a bank involved in an OTC transaction likely wouldn’t provide any itself.  Settlement would typically only occur at the end of the contract.

Why Congress wants standard derivatives

Transparency–the idea that regulators can know precisely at any time what the overall market position is, as well as what risk each individual participant in the market is taking–is the main reason.  Also, the existence of the exchange/clearinghouse as an independent third party to compel participants with losing positions to supply additional cash to their margin accounts is a significant protection against default.

Why the banks don’t

The OTC derivative business is very profitable under normal circumstances.  Customers may find it difficult to comparison-shop for complex products.  They may also fear that in doing so they will make their intentions widely known, drawing too much attention to a market inefficiency they hope to exploit.   Thus, they will tend to deal with only one or two banks and not worry that much about price.  Also, in really complex transactions, a non-expert customer may not be able to figure out very accurately how much of the price is cost and how much is profit.

Some customers may find the cash requirements of daily margin settlement too cumbersome.  Some may have contracts with clients that don’t allow them to borrow money.  This precludes setting up a margin account.   OTC derivatives are a way of getting around the restriction.  In these cases, you’d figure the bank charges a higher fee for providing a service the customer can’t get by other means.

Exchange-traded derivatives are less profitable because the contracts themselves are a commodity.  Also, gains would be split among the owners of the exchange, in proportion to their equity shares.  So there’s no possibility for firms with more skillful marketing to gain a higher market share.

Why non-financial companies don’t, either

Non-financials are contending they should be exempt from any requirement to use exchange-traded derivatives.  Their main argument is that, unlike the banks, they had no role in causing the financial crisis.  At present, they use OTC derivatives because their financial strength means counterparties don’t demand cash collateral.  Using exchange-traded derivatives, which would demand large amounts of cash margin, would be much more expensive.

What will likely happen?

I think Congress will order a massive move away from OTC derivatives to exchange-traded, in order to curb the activities of the banks’ proprietary trading desks.  Non-financial firms will likely be able to conduct business as they have done before.

If so, the result will be substantially lower profits for commercial and investment banks, but a more stable world.  Of course, the other major banking powers around the globe must enact similar legislation, or the high-risk, potentially toxic portion of the derivatives business will migrate offshore–just as it was drawn to the UK by relatively weak regulatory supervision this time around.