The Inefficiency of Clearing Mandates

September 28, 2010

The past 30 years have witnessed the dramatic growth of over-the-counter (OTC) derivatives markets, but there was always some unease with these markets.  In the aftermath of the financial crisis, this unease has morphed into widespread fear and loathing, and attention has turned to reducing systemic risk in the derivatives markets, says Craig Pirrong, a professor of finance at the Bauer College of Business at the University of Houston. 

  • Much of this attention has focused on counterparty risk in the OTC market, where trades are bilaterally executed between dealers and derivative purchasers.
  • One proposal for addressing such counterparty risk is to mandate the trading of derivatives over a centralized clearinghouse.
  • The clearing mandate would transform derivatives markets.
  • Unfortunately, the advocacy of this initiative has been glaringly devoid of serious economic analysis of the economics of counterparty risk in derivatives markets.

Legislative and regulatory attention would be more constructively directed to facilitating the crafting of a superior means of replacing and hedging OTC derivatives positions in the aftermath of a major default, says Pirrong.

Source: Craig Pirrong, "The Inefficiencies of Clearing Mandates," Cato Institute, July 21, 2010.

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