Trading and Technology Technology
May 16, 2012
Does Dodd-Frank Need Algorithmic Help on OTC Derivative Risk?
Clearing houses for over-the-counter derivatives trades have their critics. But a new algorithm could help balance the risk.
By Katherine Heires
While the debate over the impact of new regulations to the over-the-counter derivatives market continues apace, at least one technology provider says they have come up with a way to dramatically reduce systemic risk in this arena they just need a Dodd-Frank exemption to make it happen.
Dodd-Frank is all about requiring the major banks to reduce the threat of systemic risk by raising the capital charges on their exposures to other banks a function of their interconnectivity and the fact that in the OTC derivatives market prior to the 2008 financial crisis, there was a total lack of transparency in the bilateral trades and quantity of counterparty risk that accrued. Its a huge problem that came to a head during the collapse of Lehman Brothers, and its what makes the financial system so very vulnerable during times of market stress.
One way that regulators in the U.S have taken steps to reduce risks in the OTC derivatives world a $700 trillion market is to require that clearing activity take place through a clearing house or central clearing counterparty (CCP) a financial entity whose primary function is to guarantee the performance of derivatives contracts among its participants. Assuming that the CCP is sufficiently creditworthy, it has the ability to absorb the cost of unwinding positions or failed counterparties and can mitigate the possibility of contagion in the form of default risk, spreading quickly from one member to another. ....