Streetwise Professor

June 26, 2009

Equilibrium Responses

Filed under: Derivatives,Economics,Exchanges,Financial crisis — The Professor @ 4:56 pm

Soon after posting my piece on the Treasury White Paper where I repeated my argument about the failure of most regulators and commentors to think through the equilibrium responses that would likely occur as a result of regulatory changes, I came across this Seeking Alpha post by David Enke that makes the point nicely:

Gensler believes that “central clearing will further lower risk,” but will it? While this is probably true initially, the long-run benefits could disappear. How so? Given that dealers will need to abide by stricter capital and margin requirements, the capital requirements will no doubt continue to grow as the added liquidity risk of less actively traded contracts is accounted for. While again this seems sensible, the extra cost will force even more contracts to move on to the exchanges. This will in turn reduce the amount of OTC contracts that are likely to be offered. Once again, all good, right? Not necessarily.

One of the benefits of OTC contracts is that you can develop a specialized contract that better matches the risk you are trying to hedge. Standardized contracts do not offer the same flexibility, causing a company to enter into less than perfect hedges, thereby making the company more risky over the long-run. This has the effect of causing risk management to be more expensive and less efficient for companies, just at the time when additional risk management is being encouraged.

Once again, raising capital requirements on risky assets has some obvious benefits, but hopefully the added burden is not so much as to eliminate the efficient use of the OTC market. If this happens, regulators may find themselves dealing with yet another problem.  

Just so.  Couldn’t have said it better myself.  

The statement about “eliminat[ing] the efficient use of the OTC market” gets to the nub of the issue.  The Geithners, Genslers, and legislators looking to clamp down on the OTC market seem to believe that “efficient use of the OTC market” is an oxymoron.  I think that they are they are wrong, and in their misguided distrust of these markets, they will make things worse, not better.

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1 Comment »

  1. Of course “efficient use of the OTC market” isn’t an oxymoron. It’s just very difficult to define. I think the problem here is “overuse” or “misuse” of the OTC market to alchemically eliminate risk.

    I think mistrust of these markets — since it is PRECISELY these markets that allowed AIG to underwrite essentially the entire US mortgage market — is well-founded.

    Hiding risk through complicated counter-party shenanigans isn’t “risk management.” It’s magical thinking that risk can be entirely removed. If a little “inefficiency” in risk management forces companies to adequately account for the risks they are taking, it’s efficiency well lost.

    Comment by Michael Blackburn — July 1, 2009 @ 2:14 pm

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