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The author wishes to thank Clas Bergstroem, Bankim Chadha, Peter Englund, Todd Smith, Matthew Spiegel, Staffan Viotti, an anonymous referee, and seminar participants at the International Monetary Fund and the Stockholm School of Economics for helpful comments. Any remaining errors are those of the author.
Patrick H. Arbor, the former Chairman of the Chicago Board of Trade (CBOT). Quotation taken from his testimony before the Risk Management and Specialty Crops Subcommittee of the (U.S.) House Agriculture Committee, April 15, 1997.
Speech delivered at the 2000 Canadian Annual Derivatives Conference by Leo Melamed, chairman emeritus of, and senior policy advisor to, the Chicago Mercantile Exchange.
OTC markets are by no means unregulated, but rather self-regulated. Industry associations such as International Swaps and Derivative Association (ISDA) provide the OTC markets with standard legal contracts for most types of instruments. This paper assumes, not unreasonably, that this self-regulation gives the OTC market a significant cost advantage over organized exchange markets. For more information, see www.isda.org.
Group of Thirty (1993). The Group of Thirty is a group established in 1978, which is a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia.
The economic importance of the global derivatives market can not be overstated. As a comparison, as noted in Schinasi and others (2000), world GDP reached US$31 trillion and global net capital flows totaled US$394 billion in 1999.
See BIS (2002). The notional value of the OTC derivatives outstanding has been adjusted for double counting and other well-known measurement problems.
For the second quarter of 2002, seven commercial banks accounted for 96 percent of the total notional amount of derivatives held by the U.S. banking system (estimated at US$50 trillion; see OCC, 2002). OTC derivatives accounted for 90 percent of the total, and the remainder was in the form of ODE contracts.
Which is indeed the most frequently cited reason to use the OTC markets, the OCC attributes the rapid growth in OTC derivatives to “banks clients’ increasing use of customized solutions for risk management problems” (OCC, 1999).
They constitute about 4 percent of volume traded on NYSE. Their insignificant presence is also valid on the major derivative exchanges (not agricultural commodities though).
As is standard in the literature, and for simplicity, we assume that there is no initial endowment of some non-risky asset.
Maximizing a standard mean variance utility function with normally distributed pay-offs is equivalent to maximizing a negative exponential utility function exhibiting constant absolute risk aversion.
The derivation of the individual’s optimal volume is relatively straightforward and more details are provided by Tashjian and Weissman (1995) or Duffie and Jackson (1989). As is standard in the literature, no specific budget constraint is assumed in period 0 and agents do not default on their future payment. For a relaxation of the latter assumption please see Santos and Scheinkman (2001).
Demand equals supply in equilibrium so the total transaction volume is equal to two times the demand.
As stated in Duffie and Jackson (1989), Proposition 1. See the previous table for a definition of the parts of the endowment differential.
An alternative budget constraint which would be more closely related to a value-at-risk type set up, could be to put an upper limit on the variance of the OTC market’s total market exposure. Such a limit would, however, unnecessarily complicate the subsequent derivation without much additional insight.
This fairly straightforward result was shown in more detail and discussed in an earlier version of this paper, but was left out in the current version for the sake of brevity. The derivation is available from the author upon request.
The derivation for the λk s assumes that the OTC market ranks the agents and their demand to transact by the profitability each transaction generates for the market. At some point, i.e., Ω, there is a limit for the OTC market to take on risk. At that limit and for that particular agent affected at that limit, λk is different from 1 and affects the pricing decision for both the contract hedging m-risk and that hedging e-risk.
This is not a key assumption, but reduces somewhat the notation necessary to derive the final model. Hence, it is indeed possible that speculators providing much needed liquidity in the ODE market could offset some of their exposure in the OTC market, which would imply that the partitions buying ODE contracts and OTC contracts hedging m-risk are not necessarily the same. Relaxing the assumption would also raise the interesting question of whether speculators in the ODE market are actually hurt by the introduction of an OTC market.
Note that if there is no constraint on the OTC market’s ability to take on risk, or if it is not binding,
The volume traded is a positive number since those agents’ with a negative endowment tend to buy the OTC derivative, i.e.,
Assume two agents, one that wants to buy the OTC contract hedging m-risk and one that wants to sell the contract. The bid/ask spread is derived by subtracting the price charged by the OTC market to the seller from that charged to the buyer. By substituting in the agents optimal demand/supply it turns out that the optimal bid/ask spread that the OTC market charges is the transaction cost charged by the ODE market. Hence, as the transaction cost in the ODE market is increased it is optimal for the OTC market to follow suit, i.e., doesn’t compete on price.
Several clearing houses have been recently set up to clear fairly standardized OTC transactions, e.g., Brazil BM&F, Sweden’s OM’s Tailor Made Clearing, and the London Clearing House’s Swapclear. For more information see BIS (1998) and the President’s Working Group on Financial Markets (1999).
This can be easily seen from a comparative static sense by setting the γ s equal to each other. In that case, the gross volume traded in the OTC contract hedging m-risk directly decreases overall ODE trading volume, optimal transaction cost, and, as a result, ODE revenue.
Swaps and OTC derivatives were, however, not exempted from anti-fraud and anti-manipulation regulation.
For a definition see ISDA (1999), but basically “eligible swap participants” are financial corporations and high net worth individuals, i.e., not the broad public.
Other than exempt securities, such as government bonds. The agreement that restructured the scope of the CEA and its relationship to the Securities and Exchange Commission was called the Shad-Johnson Accord.
Securities that were not exempted and fell on the borderline in the Shad-Johnson Accord.
See page 2 of the report for a summary.
In September 2002, U.S. Senators Harkin and Lugar proposed expanded regulation of the OTC markets. The federal regulatory and supervisory agencies quickly issued a strong statement against such initiatives.
CBOT recent decision to launch an interest rate swap contract is one example of a likely successful strategy.