A Theory of Market Design: The Split Market Paradigm.

Abstract

The cost of systemic risk in the over-the-counter (OTC) derivatives market is described and estimated. Modern portfolio theory (MPT), applied to OTC derivatives, predicts this cost, which has been growing since 1970. This cost grew because Congress blocked MPT’s predicted market forces. Without Congressional intervention, derivatives dealers would either have held dramatically smaller portfolios or made OTC derivatives negotiable. We estimate the global market has reached an un-booked negative market value, the implied capital cost of derivatives’ credit risk, substantially in excess of $250 billion today. At the banking lobby’s behest, Congress serially altered the bankruptcy code, transferring derivatives’ implied credit risk from derivatives dealers to others. However, the burden of the transferred credit risk was not reassigned. Thus the risk is not accounted for and not supported by bank capital. Worse, since derivatives are credit-riskless for derivatives dealers, these dealers create more derivatives than if they bore the cost, creating systemic risk.This risk, and the resulting changes in bankruptcy code, are unnecessary. If the dealer community were to modify the structure of OTC derivative instruments, derivatives’ credit risk would be dramatically reduced. Without Congress’ intervention, this might have happened long ago.The article is organized as follows. The introduction summarizes the article. The second section describes how OTC derivatives create temporary excess credit risk. The third section describes government intervention in this market and the resulting permanent systemic risk. Section four estimates the current size of systemic risk. The final section concludes.