One of Geithner's six measures to contain systemic risk and prevent financial crisis is to process OTC derivatives through clearinghouses and to move a large portion of OTC derivatives onto exchanges. This change could have the following effects:
1. Exchanges' volume (and profit) will increase. (Considering the recent gains of the CME group and Deutsche Boerse, it seems the market agrees.) More importantly, their operations will evolve. Derivatives are an emerging technology with powerful risk managment applications. Like other new technologies, they still need time before users figure out how to use them safely. The dangerous application of derivatives for risk management was most evident in the role of AIG during the credit crisis. Many financial institutions hedged their exposure to bad credit with credit default swaps from AIG. Hence, it would appear that derivatives adequately distributed risk, when really they just concentrated all the risk in one counterparty. These CDS were also used to bypass capital requirements. Geithner's plan takes strong steps to prevent this misuse in the future by limiting counterparty risk.
2. But limiting counterparty risk also has negative side effects. Geithner's plan includes "robust margin requirements," to prevent firms like AIG from making hundreds of bets without any money down. While margin requirements discourage excessive speculation and go-for-broke strategies, it is also a drain of liquidity. Assets held on margin cannot be productive assets necessary for business operations. They must be passive assets that are not used by the company.
On an aggregate level, this represents a significant loss of liquidity in the financial system as it slows the velocity of money. Instead of sitting in idly, these funds could be used for capital expenditures that grow the economy. The margin requirements will have an especially strong effect on distressed or highly levered companies who do not have easy access to capital. Having to pay a margin for a simple, unrisky derivative like an interest rate swap makes these instruments significantly more expensive since liquidity holds an especially large premium for these companies. If it becomes impossible to make interest rate swaps without posting margin, many of these already vulnerable companies will simply take the risk. One company I was recently looking at has 8bn of floating debt and would have needed 400m margin in order to hedge the interest rate risk associated with this debt.
3. I predict interst rate swaps will still be available OTC, though I expect the fees will be higher to compensate for a lack of margin requirements. This will essentially be a liquidity premium. If the market develops in this way, it would actually benefit the banks by keeping OTC volume. Banks make very high profits off OTC derivatives from their ability to shave off a few basis points here and there. (JPM had 5bn in profits from OTC derivatives in 2008.) The profits from OTC derivatives could also be more evenly spread out among banks. Geithner's plan includes margin requirements for OTC dealers as they have greater systemic risk. This means the large dealers like JPMorgan might have to decrease their volume. Naturally, the extent to which this occurs depends on the exact margin rules and the degree to which OTC derivatives are moved to exchanges.
