Column : The right turf

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: For many years, turf wars have shaped Indian thinking on the role of privately negotiated (or ‘OTC’) derivatives as opposed to the derivatives transacted transparently on an exchange. The global financial crisis has underlined the importance of using public policy to encourage standardised products to be traded on exchanges. At the same time, there is a legitimate and important role for OTC derivatives in doing customisation.

Derivatives trading can be organised in two ways. The first way, which is as old as mankind, consists of private conversations between counterparties. Such transactions are an essential part of economic freedom: Contract law must allow consenting adults to enter into complex contingent claims. This is termed the ‘over-the-counter’ or ‘OTC derivatives’ business.

There are two classes of problems with OTC derivatives. First, transactions are negotiated privately. There is no guarantee that a trade has been done at the best price. This can be a cover for banks to sell products at unfair prices to customers. Alternatively, there is a possibility of corruption where an employee of a financial firm does a transaction at a wrong price, and gets a bribe in return.

The second problem is that of counterparty risk. An OTC derivatives position is a private contract between two players. When one of them goes bust, the other is left holding a non-performing contract.

Derivatives markets are very big, with trillions of dollars of positions worldwide. When a firm has very large OTC derivatives positions, this can generate systemic risk. There can be a ‘domino effect’ where the failure of one firm triggers off bankruptcies of others. A few weeks ago, Bear Stearns was a very large player in the OTC market for credit default swaps (CDS) and it was in distress. Putting it into an ordinary bankruptcy process would have generated a disruption for all the counterparties, possibly across the entire CDS market. This motivated an involvement for the US Fed, which gave J P Morgan a short-term line of credit to assist the purchase of Bear Stearns by J P Morgan.

In sum, while derivatives are integral to the modern economy, and OTC derivatives largely play a very useful role, there are some fundamental design flaws in the OTC approach to transactions. The two problems can be addressed by better market design for the class of OTC derivatives where the contract structure is standardised.