While it has to be accepted that not all derivatives can be traded as standardised products the overwhelming majority could be accommodated on exchanges if a few simple modifications were made: in particular, the available expiration dates have to be frequent enough (monthly series) so that most requirements can be handled. Does a corporation really need to hedge interest rate risk to a date outside the available expiration cycles? We do not think that is necessary in the majority of cases. With sufficient incentive (different capital and accounting treatment in favor of listed derivatives) most companies would choose standard contracts. Concentration of activity in listed exchanges would create a tremendous increase in liquidity and this - in addition to much higher transparency in pricing - would lead to a snowball effect in favor of listed products. Would clearing houses be able to accommodate the rise in volume and consequent rise in risk in case one party should fail? This certainly could be a problem but at least the problem would be out in the open and not hidden in the (off)balance sheets of banks (usually in the footnotes). There they are posing the same level of risk but it is clear that the only guarantee in case of a failure of a counter party is the (implicit) guarantee by the taxpayer. A clearing system has to be designed to be robust enough to withstand any conceivable failure. This means sufficient margin collateral. Stress tests have to be designed so that even dramatic price changes like those experienced in the 1987 stock market crash of in the recent credit crunch pose no risk to the system.
P.S.: Today's article in The Times about disputed valuations concerning the sale of Lehman-related derivatives during a margin call illustrates that trading of derivatives on exchanges would create a more transparent pricing system.
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