OTC versus Exchange Traded

Now that health reform has been passed in the US it seem that the next piece of regulation that the Obama administration is targeting is Financial Reform. I haven't read yet the senate proposal, but it seems that among its clauses there is one that will require that financial derivatives to be traded in exchanges. This is in contrast to the current practice where the bulk of these trades are done in the OTC market. What is the difference? Well, simply put, an OTC derivative is a custom made contract, whereas the ones traded in exchanges are standardized products (you have, say, a limited number of maturities for futures or maturities and strikes for options, whereas in an OTC you can get for yourself any desired contract); but more importantly (and the reason the government wants to push the market in that direction), derivatives traded in exchanges are margined everyday, thus almost eliminating counterparty risk (i.e. the risk that one of the involved parties doesn't fulfill is obligation).

So far so good, the market will loose creativity so to speak in the area of Financial Engineering, but we will probably finish up with a safer financial system. What is not clear to me at all is if this requirement will apply to any financial derivative or if they have a subset of these in mind (it is clear that, for example, Credit Default Swaps will be pushed to exchanges; but I'm not sure if, for example, from now on all FX options have to be exchanged traded). I suspect it will finish up being the second one, and that implies that some government agency will have from time to time to cherry pick which derivative should stop being OTC to become market traded. That to me sounds like a very bad idea, moving derivatives from OTC to market based should be something that the involved parties have an incentive to do, and that can be achieved through higher capital requirements on OTC derivatives. There is no need for a super-bureaucrat, that will only end up in corruption and in another round of regulation.

Nacked

Yesterday it was announced in Germany that the short selling of certain securites would be suspended for some time. As soon as this was announced I saw several comments in twitter that this was a bad idea. Two things I'd like to mention: 


1. The measure is actually quite mild, it only covers what is known as nacked short, i.e., selling something you don't even own. Shorting securities is still feasible in Germany, you just need to find someone that lends you the security first. 


2. Why would anyone consider this a bad idea? What actually surprised me was to learn that in Germany nacked short selling was allowed. In the US that is not allowed except for market makers and I think that is the way to go. 


Don't get me wrong here, I do believe short selling performs a useful service (for hedging purpuses and for finding Lehman's and Enron's, for example), but markets tend to overeact (overshoot if you want to sound more fancy) and when they do so on the downside the results can be quite scary. Given this a little sand on the wheels does not sound ludricous to me and this one seems to be the least intrusive way. In short: I agree on this one with the German authorities--not that they care of course.

Mandated Benefits

Just quickly reread "Some simple Economics of Mandated Benefits" by Larry Summers, it is amazing how much you can get out of a simple graph, and so sad that you rarely hear people arguing in a disciplined manner, just shouting.

The original article I was able to find it online at: http://www3.amherst.edu/~jwreyes/econ77reading/Summers.pdf

Two Different Problems: Liquidity and Insolvency.

1. Liquidity.

At this point it is probably the only thing the US regulatory authorities know how to cope with, “thanks” to the Great depression of 1929.

2. Insolvency.

That is what the Great recession of 2008 (that is how it is getting fashionable to call it, although given what it is happening in Europe we might need to change that) should have teach us, but I am not sure it will given that we felt it as recession and not a depression.

Institutions to cope with default are what we need: Too Bigh to Fail is neither fair nor efficient.

Suggested Readings:

Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis (Hoover Institution Press Publications). John B Taylor.

Financial regulation: Can we avoid another great recession? John Van Reenen
(http://www.voxeu.org/index.php?q=node/4988. May 4, 2010)