An FT article I read earlier this week put me on to an interesting report on the OTC derivatives market commissioned by the City of London and written by a consultancy Bourse Consult. The report seems to be have been commissioned in defence of OTC industry against the predictable knee-jerk of regulatory proposals following the current financial crisis. Main points from the report are:
- The OTC market is global and very large, much larger (by notional I guess) than either the exchange traded market or the cash markets
- London accounts for 43% of the OTC market, with 24% in the US
- It clarifies and emphasises that CDOs on ABS sold into off balance sheet special investment vehicles are where the main losses in the current crisis have been incurred
- The CDS market and the OTC market in general did not cause the current crisis
- Being seen to be "doing something" is driving much stricter regulation for CDSs and the whole of the OTC market, not just for the CDO products at the heart of the crisis
- Those arguing that OTCs must be traded on exchanges are mistaken since the OTC market and the exchanges are complimentary and need each other to thrive and develop new products
- Many OTCs could by cleared centrally by a CCP without requiring listing on an exchange
- However desirable, there are certain types of OTCs that are not suitable for a CCP
- The current crisis was caused by mistakes by the ratings agencies, poor risk management by the banks and a lack of questioning of these participants by the regulators
- Fundamentally this is a people-led not product-led crisis
- Pressues to set up regional CCPs are mis-guided as the OTC market is a globally one and ultimately it will decide which CCPs succeed.
The report is well written and well worth a read. However, to suggest that the current financial crisis is purely people-led and that financial products are blameless is not completely the case in my view. I guess it depends upon your interpretation of whether regulation should directly limit the types of financial products created and their usage, or simply focus on regulating the people who are creating and using them. Given the current focus on getting CCPs set up for CDSs and other OTCs, it seems like governments and regulators are taking the approach of directly addressing perceived issues with financial products in addition to the more obvious (but more difficult?) people issues.
Also sounds like there is some work to be done in the EU, US and elsewhere if London is to remain the global centre of the OTC market – given the current performance of the UK Government this is not an encouraging prospect for London.