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WFE Focus January 2011
OTC markets and systemic risk
Peter Clifford
Deputy Secretary General,
WFE

One of the reasons that investors look to exchanges is that the products listed and traded there are done in a way that was easily comparable.

Exchanges standardize the rules for raising equity capital and trading stocks, and they standardize the characteristics of their futures contracts and options. This makes it easier to assess the performance and returns, and it promotes liquidity and transparency. The downside is that standardization might restrict the possibility for a corporation to find a suitable product to protect itself from risk. And so, the over-the-counter derivatives (OTCD) market found its calling.

As the OTCD world developed into an enormous, opaque and highly leveraged market, exchanges and clearinghouses answered the calls of their clients to find more flexible ways to trade in an exchange environment or though a central-counterpart clearing arrangement.

In this edition of Focus, we look at three of the many solutions that are in use today to lessen the systemic risk from OTC derivatives. These initiatives come from exchanges, clearinghouses and central repositories and are just a sample of the work underway.

These developments also represent innovative solutions tailored to the needs of market participants using OTC markets, and leveraging on the benefits of the exchange environment (price transparency and discovery, central counterparty clearing) to mitigate systemic risk.

The FLEX options contracts created by CBOE; Eurex’s wholesale facilities for derivatives clearing and the DTCC’s derivative depository are part of a roadmap to safer markets. The evolution of all these products highlights a strong level of cooperation between exchanges, regulators and market participants that bodes well for the future.

It will take a concerted effort to shift the current market practices to less risky solutions. The comparing of industry data from the exchange traded derivatives and the OTC world highlights the need to enact the reforms.

While exchanges, clearinghouses and repositories are seeing high growth in these risk-hedging products, the overall impact in the OTC space has yet to achieve its potential.

A recent report by the Tabb Group points to potential savings if clearinghouses and transparent trading solutions are used, and also highlights the amount of systemic risk still in the system.

Romain Devai, Research and Projects Manager at WFE, starts this edition of Focus with a review of that study that you may also find on the WFE website. Notice: Undefined variable: indexpage in /home/wfe/public_html/focus/2011-01/footer.php on line 4
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