Appeared in The Financial Times on 26 April 2009
The report* that has just been published by the City of London on over-the-counter (OTC) derivatives makes for alarming reading if, like me, you believe that politicians and regulators should approach the financial crisis as the medical profession would approach a sick patient: by diagnosing the illness and then prescribing treatment.
There are a couple of characteristics of the OTC markets that are important to recognise.
First, they are much bigger than the markets that are conducted on exchanges. The report shows that the market value of OTC derivatives contracts is eight times larger than exchange-listed derivatives, and that turnover in exchange-listed derivatives is in turn 25 times the turnover in traded cash equities, This gives some sense of the relative size and importance of these markets.
Second, London is the most important centre for the OTC markets. It is estimated that 43 per cent of worldwide derivatives trading in 2007 was conducted in London, whereas 24 per cent was conducted in New York, and less than 15 per cent in France, Germany and Japan combined. OTC markets are important to the City of London in its widest sense, including the offshoots in Canary Wharf and Mayfair.
This makes it all the more worrying that the prescriptions put forward for the OTC markets show a blatant disregard for the facts, and the cultivation of self-interest by politicians and some operators.
Let’s start with the simple proposition, which seems to be almost universally accepted, that the OTC markets in credit derivatives were one of the main causes of the crisis. The City of London report utterly refutes this claim. There have been no significant problems caused by the markets in credit default swaps. In fact, the market survived a severe test with the failure of Lehman Brothers without any ill effect.
Despite this absence of any evidence that the OTC markets in credit default swaps have caused any problem, there is a clamour for a central counterparty to guarantee trades in the CDS market and even for CDS trading to be conducted on exchanges. We have seen Tim Geithner (when he was president of the New York Federal Reserve) indicate that the OTC CDS market should be regulated by the US, which is amazing since three-quarters of the world’s CDS trading takes place outside the US.
Not to be outdone, the European Commission has threatened legislation imposing stringent new controls unless the banks that are the main dealers in CDS establish the use of an EU-based central counterparty for CDS by the middle of the year. The practicality of achieving this has, of course, not been considered, let alone the desirability.
Last but by no means least, the Banque de France has proposed that a central counterparty needs to be established for the eurozone – in other words, one that is not located in London, since the UK is not in the euro.
Added to this mêlée is the suggestion, for example in a submission from the Federation of European Securities Exchanges, that CDS (and other OTC) trading can be transparent, liquid and well regulated only if it is conducted on exchanges. This assertion, which is equally unsupported by any evidence, is promoted by those exchanges that are seeking legislative or regulatory help to drive OTC business on to their platforms.
Their action is not surprising since they have almost universally failed to make any inroads into the OTC markets. There are many reasons they have failed, but the largest one is that OTC market products are of necessity bespoke instruments and contracts, traded in large amounts between professional participants; and as such, they are the antithesis of an exchange-traded product. If OTC business is driven to these unsuitable venues, markets will become less efficient, which is an outcome we should seek to avoid.
Given the importance of OTC markets to London and to the health of the financial markets in general, the British government should surely be lobbying to support the City of London report’s conclusions. But as we saw last week, its priorities would seem to lie elsewhere.
* Current Issues Affecting the OTC Derivatives Market and its Importance to London by Lynton Jones of Bourse Consult
The writer is chief executive of Tullett Prebon