Exchange traded vs. OTC

The MIFC book has argued (page 152-153) that there is a case for a policy bias in favour of exchange-trading over the OTC market.

On 5 October, Stephen Cecchetti argues in a similar vein in the Financial Times:

In September 2006 Amaranth Advisors, a US-based hedge fund specialising in trading energy futures, lost roughly $6bn (4bn) of the $9bn it was managing and was liquidated. With the exception of its shareholders, most people watched with detached amusement. Eight years earlier, reaction to the impending collapse of Long-Term Capital Management was very different: people were horrified and the financial community sprang into action. One big difference is that Amaranth was engaged in trading natural gas futures contracts on an organised exchange, while LTCM's exposures were concentrated in thousands of interest-rate swaps.

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The difference between futures and swaps is that futures are standardised and exchange-traded through a clearing house. This distinction explains why Amaranth's failure provoked a yawn, while LTCM's triggered a crisis. It suggests that regulators, finance ministries and central bankers should be pushing as many securities on to clearing house-based exchanges as possible. This should be the standard structure in financial markets.

A critical part of any financial arrangement is the assurance that the two parties to it meet their obligations. In organised exchanges, the clearing house insures that both sides of the contract will perform as promised. Instead of a bilateral arrangement, both buyers and sellers of a security make a contract with the clearing house. Beyond reducing counterparty risk, the clearing house has other functions. The most important are to maintain margin requirements and "mark to market"gains and losses. To reduce its risk, the clearing house requires parties to contracts to maintain deposits whose size depends on the contracts. At the end of each day, the clearing house posts gains and losses on each contract to the parties involved: positions are marked to market.

Since margin accounts act as buffers against potential losses, they serve the role that capital requirements play for banks. Marking to market offers a way to monitor continuously the level of each market participant's capital.

Finally, exchange-traded securities are standardised, creating transparency: buyers and sellers know what they are buying and selling.

Returning to the comparison of Amaranth and LTCM, we can see why the former did not provoke concerns of a systemic crisis. Amaranth was required to hold margin to maintain its position in futures markets. When it started to sustain losses, the clearing house forced the sale of the positions into a liquid market; counterparties sat calmly, knowing their interests were protected. By contrast, the swaps LTCM held were with specific institutions. Since interest-rate swaps are not exchange-traded, selling them was not feasible. The collapse of LTCM would have led to defaults on the contracts and put other financial firms at risk.

This brings us to the present crisis. The defining feature is that there are securities out there no one knows how to value. We discovered this when poten- tial investors refused to accept certain mortgage-backed securities as collateral in the issuance of commercial pap-er. A failure of investors to monitor the originators of these securities had led to the creation of complex and non-transparent securities. If these were ex-change-traded through a clearing house, these problems would largely disappear.

There are many ways to encourage people to move trading into clearing houses. Are there tax and regulatory incentives that are doing the opposite? Are banks, insurance companies and pension funds being rewarded for holding difficult-to-value securities that are not exchange-traded?

The goal is to structure financial markets in a way that minimises -system-wide risk. Yet we also need to remember that there are gains to asset-backed securitisation. When the system works, it turns illiquid bank loans into readily marketable securities. This should reduce the overall riskiness of the financial system. Shifting these securities to exchanges with clearing houses would help ensure that these benefits materialise.