City of London defends OTC derivatives markets

Political pressure for reform risks crushing the over-the-counter derivatives market, warns a report published today by the City of London.

The City of London Corporation emphasised the report, produced by the UK financial markets consultancy Bourse Consult, did not necessarily represent its position and was meant for discussion only.

The corporation blames the financial crisis on "the major guilty parties... collateralised debt obligations on asset-backed securities which were sold into highly leveraged special investment vehicles held by banks as off-balance sheet assets".

Credit default swaps (CDS) were not significantly involved, but nonetheless face much heavier regulation in the eurozone and the US. "In accepting the inevitable additional regulation that will come, it is important that the very successful OTC derivatives market is not crushed in the process," wrote the report's author, Bourse Consult's Lynton Jones.

He blamed the incompetence and overconfidence of banks, rating agencies and regulators for what he called "a crisis caused by people's misjudgment, not a product-led crisis", and argued against "misguided" pressure to set up regional central counterparties for derivatives in the US and the eurozone.

The report has been sent out to various companies operating in the City "to prompt discussion", a City of London official told Risk, but added there are no plans so far for any follow-up discussions or exercises.

Several exchanges plan to launch CDS clearing services in Europe this year, and the bulk of the interdealer market has now committed to use central counterparties in response to pressure from regulators and central banks to improve the infrastructure of the CDS market. But the OTC market has also come under fire for assisting speculation and lacking transparency - last week the New York Fed's senior vice-president Theo Lubke said it was "simply unacceptable in today's environment that the design and structure of the OTC derivatives market can be controlled by a handful of large dealers".

See also: Isda AGM: US regulator identifies six weaknesses in OTC market
Dealer predicts 85% of CDSs could be centrally cleared by end of 2009
Trichet: Eurozone CCP will help improve oversight
Banks agree to EU CCP for clearing CDS