Column : The right turf

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: exchange. Instead of private conversations, all orders would go to exchange screens. The order matching procedure at the computerised exchange guarantees that every order is matched against the best price. It thus ensures sound procurement: the buyer has a guarantee that he is getting a product from the L1 seller. The problems of customer abuse and of corruption are both solved. This is particularly important for PSU financial firms, where the CVC needs to be assured that L1 procurement was done.

The problem of credit risk is solved by a clearing corporation (CC). Once a trade has taken place (whether OTC or on exchange), the CC interposes itself as the legal counterparty to both parties. It does risk management of both exposures. If one party goes bankrupt, the other is not affected. This eliminates the externalities of failure. It makes possible greater creative destruction, because government does not have to come in the way when firms fail.

Both these innovations—electronic exchange and CC—are not universally applicable to all OTC derivatives contracts. They are only applicable to standardised contracts, such as the bulk of the forwards and swaps which are now being traded on the Indian currency derivatives market. There is a legitimate role for OTC derivatives in achieving complex contracts (also termed ‘exotic’ derivatives) that are delicately customised to the needs of a client. The architecture here is that financial firms create these complex, customised solutions, and thus add value, while hedging off these exposures using the standardised exchange-traded derivatives.

In the Indian debate, RBI has long emphasised OTC derivatives and tried to prevent the emergence of exchange-traded derivatives. This has been motivated by turf considerations, because exchanges would be regulated by Sebi. The Percy Mistry and Raghuram Rajan reports have emphasised the importance of exchange-traded derivatives, and of the unification of regulatory functions for all organised financial markets (whether OTC or on exchange) at Sebi. The recent events in global finance amplify the importance of exchange-traded derivatives. The credit default swap is a perfectly good product—as long as it is transacted on an exchange with a CC. When transacted OTC, it has helped induce systemic risk.