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OTC clearing...who's afraid of the regulators?

According to the latest reports, the European Central Bank (ECB) is once again asserting its right to be more closely involved in shaping the OTC derivatives and clearing regulations. I, for one, would welcome greater involvement and oversight from the central bank. The ECB has every right to be included in any regulatory talks concerning, well, many of the European banks. Furthermore, we should not forget the mistakes of the recent past; once the student misbehaves, the teacher is right to focus more on their behaviour. Once bitten...

I’m slightly bemused why there is so much furore surrounding OTC derivatives reform. The main impact of the regulation is that most of the market will go electronic and trade via a central ‘exchange’, which is essentially how most other investment vehicles are currently traded.

Aren’t regulators just taking a commoditised view of the OTC derivatives market in a similar way to equities and FX? In the long run, won’t any central counterparty (CCP) operate just like the LIFFE, Eurex or any other exchange, with a bit of collateral thrown in?

Where the ECB, alongside the ESMA, should however focus its efforts, I believe, is around the question of whether last resort liquidity support should be provided to CCPs. The effectiveness of the CCP model is yet untested, but the option of not providing such protection could lead to the collapse of a CCP, perhaps causing a systemic collapse, if there were too few CCPs. If such support is provided however, it is likely to discourage CCPs from developing the most effective risk management and margin models, since they will essentially expect to be "bailed" out. That expectation will likely mean that services are provided at the ‘wrong price’ because they are using the ‘wrong risk’ measure.

In the long-term, such insurance could make people dealing with OTC derivatives less focused on ‘getting it right’. Ultimately, why should one exchange receive protection when the others do not? Perhaps protection could come in the form of an early check system that then provides compulsory liquidity at a very expensive price, ensuring that once help is needed, it comes at a punitive level but before a catasrophe ensues.

Hopefully, these are some of the issues that the ECB can work through alongside the ECSB, since surely two heads trained on the problems are better than one.



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