There has been a lot of talk in the press and the offices of global regulators about OTC contracts in the last few days - much of which is absolute twaddle, some of which makes some kind of sense...

This all seems to have been based upon the demise of Bear Stearns, claiming that the US Fed had to step in because of their huge risk exposure in the OTC market and the chaos that would have ensued should such an important counterparty unwind. This is only partially true as Bear's exposures were not just to the OTC market, and their fall would have caused ripples in many more markets than OTC derivatives.

However, they were exposed to huge OTC risks, and this has raised the question of central counterparties. The exchanges have therefore leaped in and claimed that all would be safer should all OTC contracts be on-exchange. Now whilst this is conceptually true (as you would get price and valuation transparency, systematic margining, no confirmation backlogs etc etc) this is not exactly a practical solution. The whole point of OTC contracts is that they are bespoke - tailored precisely to the needs of the investor and most therefore cannot be standardised, or if they were would lose their appeal and volumes would plummet. There is also another point to note - the exchanges clearly have their own agenda that they are following. The volumes of listed derivatives that are traded are dwarfed by the OTC market, and they have been trying for years to grab a piece of the pie (see article on the failure of listed credit derivs). And besides, before any of this can happen the thorny question of who should be allowed to clear through the central counterparty. Should it be a limited membership (thereby concentrating risk) or open to all (thereby negating the surety of the mechanism).

All these arguments seem to completely ignore the sterling work that ISDA have done over the years to mitigate counterparty risk. The huge number of trades that are now collateralised is done to them in great part and and this risk is further mitigated by the use of their standard Master Agreements.

So I guess it will be interesting times ahead for the OTC community. I struggle to see how anyone can at a stroke get rid of the OTC market. The demand for it is in the $400trillion area and I cannot believe that even with them all working together (some hope of that) that the exchanges can supply that amount of contracts