Transparency in derivatives please
The first Credit Default Swaps have now been cleared on a Central Counterparty (CCP).
It is due to an initiative by the European Commission where they demanded that the market should establish one or more CCPs by end of July 2009.
A CCP functions as the seller for all buyers and the buyer for all sellers of a standardised product. This has been known for a long time from the exchanges where futures and options are bought and sold. The counterparties don’t know each other and the exchange is the counterparty for all participants.
So if it works well for exchange traded instruments why should it not work well for OTC derivatives?
It is assumed by many people that derivatives are harming financial stability and that they played an important role in causing the crisis and they hope a CCP will magically change that.
First of all it was not the instruments that caused the crisis. The crisis came about due to poor (or lack of) risk management as banks were giving mortgages to people, who could not pay it back.
Different types of derivatives made it possible to hide, concentrate, and offload the risk to somebody else.
However for most corporates derivatives are simply insurance instruments that help them reduce risk of financial losses due to exchange rate movements or changes in interest rates. The risk of the derivatives doesn’t come from this activity. It comes from the financial institutions that use the derivatives for speculation and fast profits.
And with a Central Counterparty you don’t do away with the counterparty risk, you merely centralise it.
The next issue is that the OTC market is bigger than the exchange traded market, but it looks like there would be much fewer CCPs in the OTC market. Therefore the collapse of a CCP would have much worse consequences. We have then seen the birth of another group of organisations that will be “to big to fail”.
I believe that the way we fight the next financial crisis is not through centralisation but through transparency. It is the lack of transparency that brings uncertainty and fear and makes banks stop lending.
Now the CCPs will know the biggest positions in the market and they should be forced to share this information with the market: Which banks have which position in which derivatives? With this information you could move the risk management into the public instead of hiding it in the banks.
