Rush to Put OTC Commodity Derivatives on Exchanges

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.

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  1. Anonymous

    “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.”

    You’ve pointed out on your blog before, the person who does the first draft of a document gets a major advantage tactically. The same principle applies when an industry adopts self-regulation as a prophylactic measure to avoid or reduce anticipated oversight by regulators.

  2. tourist


    Maybe the reason they’re tripping all over themselves to get CDS on an exchange is they’re figuring they can get the federal government to guarantee the counterparty risk of the exchange.

  3. baychev

    Paul Volcker pointed to Charlie Rose another major issue: the size of the CDS market. It should shrink to 1:1 coverage of actual bonds as this CDS game is extremely inefficient and non productive use of collateral. Instead of lending to businesses or households, banks use their capital to trade no value added derivatives.

  4. doc holiday

    Ahhh, crap, bilateral contracts. Who is buying this crap anyway? There are regulations as to what investments can be held by banks and various financial entities, so are we talking about hedge funds here other unregulated pirates, who are rushing to use unregulated markets to dump trash into? Who are these nameless people? Bilateral contracts are bets between two crooks.

  5. Anonymous

    SIFMA Lobby Group Closes Market For Crooks?

    The MSCI Asia Pacific excluding Japan Index of regional shares rose 4.5 percent, after last week plunging 20 percent, the biggest drop since the benchmark was first compiled in 1987. Japan’s financial markets are shut today for a holiday as are those in the U.S., which prompted the Securities Industry and Financial Markets Association to recommend trading of cash Treasuries be closed today.

  6. wintermute

    It is simply amazing.

    In physics the observed energy of the vacuum is 10^100 times different from its theoretical value.

    Such a crazy situation should never arise in the real world of economics. Right?

    Not quite in the same league but economics is trying hard with its own discrepancy of 10*2

    I am talking about the netted payout by CDS writers on Lehman’s bond debt. Is it a mere $4bn as some sources allege. Or is it a systemic-wrenching $400bn as others suggest?

    Fortunately we will find out sooner than physicists will about quantum vacuum energy!

    But why wait? In a time of such nervousness, and increasing taxpayer liability, – it should be mandatory that all CDS claims, displaying both parties, should be loaded on the creditex website as soon as the auction finishes.
    Lets have an end to the huge unknowns of credit events!

  7. Thingumbobesquire

    It is wrong to characterize this crisis as resulting from merely the latest incarnation of monetarist speculation, i.e. the housing bubble. The credit default swap derivatives the are undergoing de-leveraging are but a small proportion of the cancerous multi hundred trillion derivatives “markets.” Until this insane gambling casino mentality is extirpated and replaced any attempt to prop it up is foredoomed. You can bet on that.

  8. Anonymous

    October 13, 2008

    All the kings’ horses, and all the kings’ men, now aided by super glue, nano technology, and quantum physics are attempting to put Humpty together again.
    Place your bets on the NYSE.


  9. Anonymous

    Proposed language for the new world financial order:

    Definition of plain understandable language:

    Language that can be understood and critically analyzed by any high school graduate with a grade B or better average.

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