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  • A Sensible Approach to OTC Market Reform

    Lee Olesky

    Officials around the world are turning to regulatory reform to address systemic risk in the global financial markets. While this is a healthy and necessary step towards rebuilding confidence in the banking system, we must take care that the very steps regulators elect to take to restore and protect, do not pose a serious threat to competition in financial markets.

    The over-the-counter (OTC) markets - securities not listed and traded on an organized Exchange - are receiving especially close attention, particularly the OTC credit derivative markets. Some propose greater regulatory oversight, including a central counterparty clearing mechanism for Credit Default Swaps (CDS). This is intended to create greater transparency and reduce counter-party and systemic risk. Others suggest the elimination of over-the-counter trading of CDS and other products, requiring they be traded only on Exchanges.

    While central counterparty clearing and enhanced transparency are eminently sensible, insisting that trading occur solely on Exchanges overlooks completely the inherent benefits of the OTC market structure. In fact, there is no logical reason for tying clearing or central counterparty functions to an Exchange.

    The proper solution for the OTC derivatives market lies in creating central counterparty clearing mechanisms that offer equal access to multiple trading platforms. This would strike the right balance between fixing systemic problems and encouraging market innovation that broadens access to credit for governments, people and business.

    To appreciate the importance and efficiency of the OTC model, one must consider the products that trade in this market and why they do so. The OTC model supports a wide range of instruments, including government and corporate bonds. These markets and their derivatives consist of an enormous number of unique issues - far more than are traded on the world's equities and financial futures Exchanges combined. As a result, specific, individual issues trade relatively infrequently, although often in significant size, and almost exclusively through the commitment of dealers to OTC market making. Issuing new and refinancing existing debt requires a market structure predicated on the willingness and desire of institutions to support the underwriting, the distribution, and the provision of secondary market liquidity for each new issue.

    To ensure liquidity in the markets, dealer banks use their own capital to make markets for these products so that clients can buy or sell them as required. This is done both directly with clients over the telephone and through regulated electronic platforms, such as Tradeweb. It has been well documented what happens when these primary institutions do not - or are not able to - provide liquidity. We've all seen the stagnation of recent credit markets and have heard what went wrong.

    By contrast, Exchange trading models have been effective for a relatively small number of highly-liquid instruments. The success rate for newer, less liquid products has been disappointing. There is a long list of unsuccessful Exchange trading initiatives over the years, including the failed launches of CDS on Eurex, and Liffe (which has not yet cleared a single CDS trade).

    Evidence of effective ongoing competition between Exchanges in similar products has not been encouraging. Indeed, the monopolistic characteristic of Exchanges was one of the key factors leading to MiFID reform in Europe to create more competition for Exchanges. Captive clearing mechanisms linked to Exchange trading further exacerbate this problem, and has lead to extensive regulatory examination and investigation of these arrangements over the past decade.

    The benefits of Exchange trading - transparency and centralised, digitised recording of trades - are also readily available in a range of non-exchange electronic OTC trading platforms. Non-exchange trading platforms often provide greater benefits, through the tailoring of systems to specific market characteristics, rather than adopting a 'one-size-fits-all' solution.

    Last but not least is liquidity. The success of a clearing solution is critically dependent on capturing the vast majority of this lifeblood of trading. Restricting trades solely to the Exchanges jeopardises key aspects of the effectiveness and integrity of clearing.

    The call to restrict OTC products to Exchange trading likely originated from the Exchanges themselves, obviously promoting their best interests. These views are also propagated by advocates who do not appreciate the crucial distinction between Exchange trading and centralised clearing.

    By keeping derivatives on a centrally-cleared OTC market, and open to multiple trading platforms, much-needed reform can be brought about, without sacrificing the innovation and competitive drive for efficiency that delivers continuing real benefits to investors and debt issuers.

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