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David Dodd
David Dodd
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Slashing Risk of OTC Derivatives

What do tulips have in common with OTC derivatives, you ask? Allow me to introduce you to the phenomenon called the Dutch Tulip Mania of 1637. During the height of the bubble in the winter of 1636, tulip traders were making fortunes of over $61,000 adjusted to current U.S. dollars per month.

If ever there was a time to begin gardening, this was it.

History is loaded with numerous examples of crises like this that have been triggered by derivatives trading - in many cases, a consequence of using them for speculation rather than hedging. The Dutch Tulip Mania saw derivative futures in tulip bulbs being swapped at extraordinary prices until there was a shocking collapse that left many investors in penury. More recently, the trading of exotic derivatives has been linked to the transmission of the financial crisis from the United States and Europe to many other parts of the world.

Over-the-counter (OTC) derivatives were at the epicenter of the global financial meltdown, with even the legendary billionaire investor Warren Buffet describing them as financial weapons of mass destruction. The hullabaloo over these products would lead us into believing that derivatives are pioneering financial instruments and contemporary creations. The reality is that derivatives have been around for many centuries, as we saw with the tulip bubble. Even the writings of Aristotle, the Greek philosopher, present evidence of derivatives trading occurring as far back as 600 BC.

Derivatives benefit the capital markets and the wider global economy by improving the pricing of risk, adding to liquidity and enabling businesses to isolate various risks and hedge those they do not like or are beyond their control. Users can then manage the remaining risks for maximizing their returns. OTC derivatives are contracts executed outside a regulated exchange and allow participants to custom-tailor products to offset business and financial risks. At the same time, these products are more complex and opaque than exchange traded derivatives and can significantly increase systemic, operational and counterparty risk.

In light of these events, global policymakers and the leaders of the G-20 group of major economies are working to address the weaknesses in the OTC derivatives markets, while preserving the benefits they offer. I welcome this type of international cooperation because it is essential in today’s markets as they operate globally and there is an imperative to minimize the potential for regulatory arbitrage. In order to improve transparency, mitigate risk and protect against market abuse, policymakers have recommended increased standardization of derivative contracts, a move to central clearing, execution of trades on electronic platforms and reporting to trade repositories. Non-centrally cleared contracts, typically bespoke products, would be subject to higher capital requirements to reflect their greater level of counterparty risk.

The supervision and regulation of OTC derivatives will create an even more prominent role for communications and networking solutions which already form the backbone of the capital markets. I anticipate an explosion of market data, proliferation of liquidity venues, more competition, better prices and increased pre-trade and post-trade transparency. Electronic trading venues would need to connect to each other and to clearinghouses and trade repositories. The OTC derivatives market of tomorrow may very well look like today’s equity markets!

While most of the focus around OTC derivatives has been on events in the United States and Europe, financial centers in Asia such as Singapore and Hong Kong have developed their own unique niches in safely and effectively trading these contracts. In both cities, we have partnered with Asia Etrading to put together a panel of industry luminaries that will shed more light on this evolving topic. I hope to see you there.

Bio: David Dodd is senior vice president, managing director for APAC.

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