Improving the transparency of derivatives trading

On improving the transparency of financial products in general and drivatives in particular, many suggestions have been put forth by academics, regulators and bankers. Calomiris mentions there are two separate issues that need to be addressed by regulators. Banks should be encouraged to move from OTC to central clearing arrangements to deal with the systematic consequences of opacity in counterparty risk. The clearinghouse, would effectively stand in the middle of all transactions as counterparty and thereby eliminate the problem of measuring counterparty risk. Clearinghouses have been quite good at dealing with counterparty risk. But clearinghouses may not be practical for highly customized OTC contracts. A regulatory cost can be imposed on OTC contracts that do not clear through the clearinghouse (in the form of a higher capital or liquidity requirement) to encourage, but not compel, clearinghouse clearing. For contracts where the social benefits of customization are high, banks’ fees will compensate them for the higher regulatory costs of bilateral clearing.

The second issue, Calomiris mentions is the problem of monitoring and controlling the net risk positions of individual banks and the systemic consequences of those positions. Requiring that all derivatives positions be publicly disclosed in a timely manner may not be practical. Disclosure of their derivatives positions could place banks at a strategic disadvantage with respect to others in the market. This might even reduce aggregate market liquidity. For example, if Bank A had to announce that it had just undertaken a large long position in a currency contract, other participants might expect that it would be laying off that risk in the future. This could lead to a decline in the supply of long positions in the market and a marked change in the price that would clear the market. A better approach to enhancing disclosure, therefore, would be to require timely disclosure of positions only to the regulator, and public disclosures of net positions with a lag.