How to stabilize OTC derivative markets

End users of derivatives including chemical companies and airlines are worried about how high the proposed “capital charges” on those over the counter derivatives that are not cleared will be set.  It is true that such charges are likely to increase costs for firms that wish to hedge risk on over the counter markets.

I’d like to propose an alternative means of stabilizing over the counter derivative markets that aren’t suitable for clearing:  Prohibit the posting of collateral on over the counter derivative contracts.  In the event that a firm trading these OTC derivatives declares bankruptcy, the derivative counterparties would have to stand in line with all the creditors of the firm to get payment.

The idea behind this reform is that the best way to stabilize over the counter derivative markets is to ensure that the only firms that are acceptable as counterparties are firms with strong balance sheets.

Since overindebted firms would in all likelihood be shut out of these markets, a transitional period would probably be necessary.  Thus, a two track uncleared OTC market could be allowed to operate for 5 to 10 years.  One class of derivatives would involve neither collateral posting nor capital charges and the other class would have capital charges that increased steadily over time until the market in “old-fashioned” destabilizing derivatives was finally shut down.

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