naked capitalism

In yet another sign reluctance to suffer counterparty risk, banks that only recently were aggressive in booking lucrative over the counter derivative trades are now tripping head over heels to shift them on to exchanges (note that the exchange, rather than the bank, would then monitor counterparty performance and be responsible for making margin calls if the value of collateral fell too far).

We had said that moving over-the-counter trades to exchanges was one of the best ways to reduce systemic risk (exchanges fail far less often than individual institutions, and the damage of those failures tends to propagate less than those among dealers enmeshed in a broad array of counterparty relationships). But it is nevertheless surprising to see this happening (at least to a degree) at the initiative of the dealers, rather than through regulatory prodding.

From the Financial Times:

Commodities traders are rushing their private bilateral contracts into exchanges and clearing houses as they race to reduce their counterparty risk amid a deepening financial crisis.

The transfer of the opaque over-the-counter deals comes as observers warn that commodities, where trading has ballooned in the past five years, could be the next market hit by counterparty failures.

Martin Abbott, chief executive at the London Metal Exchange, said the crisis was bringing new business into the LME as traders tried to reduce their risk, with turnover 45 per cent higher in September compared with the same month of 2007.

“Business that was already sitting in the OTC market is now been brought into the exchange,” he told the Financial Times in an interview.

The LME, the world’s largest base metals exchange, has extended its forward-dated futures in copper and aluminium to 10 years from five as it tries to capture OTC business.

Mr Abbott said: “When you look at [today’s] markets, it is utterly sensible to assume that being on exchange, with clearing house . . . must be attractive.”

The LME’s move comes as other exchanges are pushing into the OTC clearing business, in part to capitalise on the strong backing that regulators have given to the creation of a central clearing counterparty model for the credit derivative markets.

The aim is to reduce the systemic risks inherent when credit derivatives are negotiated bilaterally between traders by having a clearing house guarantee against default.

Regulators’ focus is on the $58,000bn credit default swaps market. The commodities OTC market is estimated at $9,000bn, according to the Bank of International Settlements.