Insight: Old thinking to manage risk

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Recent events, particularly the run on Bear Stearns (NYSE:BSC), have highlighted the vulnerability of our financial system.

While financial innovation has brought many benefits, the system has become increasingly dependent on a few key institutions to make markets in a range of new financial products.

Financial market participants and policymakers are well aware of this problem and the need for new ways to contain risk, systemic and otherwise. In fact, The Clearing Corporation and the Depository Trust and Clearing Corporation announced last week an agreement to facilitate central counterparty services for the OTC derivatives market. Citi is an equity stakeholder in TCC.

In our view, an expanded role for clearing houses with centralised clearing counterparties (CCP) in markets for financial derivatives would be an efficient mechanism for reducing systemic risk. In conventional OTC derivatives markets, each new transaction creates a new contract between buyer and seller. The handful of large financial firms that make markets in such instruments create thousands of new contracts daily.

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The history of CCPs is encouraging. Since 1925, US futures contracts have cleared through a CCP without failure, despite large shocks. Where a CCP exists, regulators can focus their oversight on its capital adequacy and monitoring efforts. Occasionally, central banks have intervened to sustain CCPs, but the frequency has been lower than in the case of individual institutions.

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Policymakers take on the complex task of securing the financial system after the storm, we encourage them to consider the potential of market mechanisms such as CCPs to advance their objectives.

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