> There's been a lot of talk about moving bilateral over-the-counter
> derivatives onto exchanges and clearing houses to eliminate, or
> at least greatly reduce, counterparty risk.
The usual complaint about this is that it "discourages innovation" -- a big part of the OTC derivatives market involves pricing "one-offs" ... essentially custom contracts. The reason for it is clear: the "esoterics" aren't available on exchanges with public, liquid markets. Forcing them to an exchange could increase the cost of such contracts to the point of being uneconomical.
However:
> Though traders will always find ways to bypass such institutions,
> this has always been high on the list of those pushing for
> regulatory reform of the financial system.
I've always thought that for certain kinds of contracts, you could have a simple rule which amounts to: when the notional value of such contracts reaches $X (and we can fuss with that, but you get the idea), or when a certain number of contracts or even counterparties are created, you have to move them and all future ones to at least a clearing house if not an outright exchange.
My reasoning is this: once it gets popular, standardization, oversight, and transparency benefits everyone.
> How effective (or not) would centralized trading and settlement of
> CDO's and other shadowy OTC instruments have been in averting the
> crisis?
It's not clear that any single thing would have "averted the crisis" -- but certainly if AIG's CDS activity had been tracked and booked by a clearing house they would have come under much more scrutiny much earlier. I think the CDS world could have been moved along to an exchange setup much earlier in its life, and certainly before the notional value of the contracts got huge like they did in 2005-2006. The industry has moved to standardize contracts and use clearing houses more slowly than if they had been forced to; there's a case to be made that by moving too slowly -- and somewhat erratically -- they hastened the demise of the product: once there emerged indexes which tracked CDS exposure, sharpies picked off the weak players. If it had all been exposed more formally, this might not have happened.
Coulda woulda shoulda, but my rule of thumb is that if a market gets big and you still can't explain it to a regulator, something is seriously wrong.
/jordan