OTC Derivatives and Central Clearing: Can all transactions be cleared?

by John Hull of the University of Toronto

April 2010

Abstract: The 2007-2009 financial crisis has led legislators on both sides of the Atlantic to propose laws that would require most "standardized" over-the-counter (OTC) derivatives to be cleared centrally. This paper examines these proposals. Although OTC derivatives did not cause the crisis, they do facilitate large speculative transactions and have the potential to create systemic risk. The main attraction of the central clearing proposals is that they will make positions in standardized derivatives more transparent. However, our experience from the 2007-2009 crisis suggests that large losses by financial institutions often arise from their positions in non-standard OTC derivatives. The paper argues that one way forward is for regulators is to require all OTC derivatives (standard and non-standard) to be cleared centrally within three years. This would maximize the benefits of netting and reduce systemic risk while making it easier for regulators to carry out stress tests. The paper divides OTC derivatives into four categories and suggests how each category could be handled for clearing purposes.

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Related reading: " Does a Central Clearing Counterparty Reduce Counterparty Risk?",
" Are We Building the Foundations for the Next Crisis Already? The case of central clearing"