What can OTC Derivatives learn from Silvers crash last week?

A key objective of Dodd Frank has been to put in place regulations for the OTC derivatives markets, that will reduce systemic risk in the financial system. The mandatory use of Central Counterparty Clearing (CCP) for cleared products is key to that strategy.

The main mechanism by which CCPs manage risk, is through the use of initial margin and variation margins to ‘mark to market’ open positions, and thus to act as a circuit breaker that reduces the risk that market participants are sitting on huge and every increasing loses.

However, will the use of CCPs actually help to reduce volatility in OTC derivatives markets?

Well, last week saw a collapse in commodities led by Silver, which dropped by over 17%.

This sell off corresponded exactly to a series of increased margin requirements by the COMEX  for trading silver futures contracts.  (goldandsilverblog.com)

The Streetwise Professor has a great article today, looking at the collapse in Silver, and examines the impact of recent changes in variation margin on the Silver market. He postulates the view that far from reducing volatility (by acting as a dampener on risk taking), changes (increases) in variation margin (on a volatile bull market) by the exchange could well have contributed to and increased volatility, as participants rushed to close positions due to increased margin calls.

The question posed by the Professor, is could the use of CCPs for the OTC derivatives markets, far from reducing risk, actually increase volatility and risk?

When OTC clearing mandates kick in, the scope for these destabilizing feedbacks will expand dramatically. (streetwiseprofessor.com)

A great read as always!

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