Question

Why did regulators encourage Over the Counter (OTC) contracts to be rebooked via central clearing?

Answer 1

In short: Unregulated market leading to no check on quantification of exposure, Lack of transparency and verifiable data on counterparty exposure in OTC markets is the reson and CCPs are seen as an answer to the systemic risk of OTC Market.

The regulators have identified OTC transactions as one of the potential causes to the global financial crisis and come to the conclusion that this market should be “secured”. OTC Derivative trades are largely unregulated and exposed to maximum counterparty risk. The common agreement has been to move the OTC trading system to a Central Clearing Party CCP platform. The main idea is to introduce CCPs, trustworthy financial institutions, in order to replace the bilateral relationships that prevailed between two counterparties, by centralized multilateral relationships involving CCPs. The seller would sell the contract to the CPP and the buyer will buy the contract from the CCP. This will introduce an effective monitoring since the CCP can stipulate the required collateral and monitor the positions of the two parties under new regulatory rules. This new infrastructure implemented for the OTC Derivative market will in theory reduce considerably the global counterparty risk observed into this market.