Central clearing of privately traded derivatives contracts won't be enough to make the $600 trillion sector safe, while clearing of some bespoke trades may not be desirable, the Bank of International Settlements said.
The lack of transparency in parts of the over-the-counter (OTC) derivatives market has alarmed regulators, particularly after U.S. insurer AIG
Lehman Brothers and Bear Stearns were also involved in OTC derivatives and when they crashed last year market participants did not know their exact exposures to the two banks.
The G20 group of countries agreed in April that credit default swaps, an insurance-type derivatives product at the heart of AIG's problems, should be centrally cleared.
A central counterparty (CCP) is widely seen as reducing risk and improving transparency in markets by ensuring there is a default fund at hand in case one side of a trade fails.
Clearing of CDS contracts has already begun in the United States and the European Union but the BIS' latest quarterly review said on Sunday this is not enough.
The introduction of CCPs alone, however, is not sufficient to ensure that OTC derivatives markets operate efficiently and remain resilient, the review said.
It is important to complement the introduction of CCPs with improvements in trading and settlement infrastructure, the review said.
Finally, introducing CCPs for nonstandard, custom-made OTC derivatives may not be feasible or even desirable, it added.
The BIS said OTC markets have been an engine of financial innovation and continue to offer cost-effective and well-tailored risk reduction products.
Preserving the incentives to create new financial instruments is important and OTC markets have clear advantages, the BIS said.
As new contract types become more widely used, however, the overall benefits from using a central counterparty will likely outweigh the flexibility offered by the over-the-counter format, the review said.
The U.S. Treasury wants as much standardization as possible of OTC contracts and for standardized products to be not only centrally cleared but also traded on an exchange if possible.
The EU's executive European Commission is also studying likely regulation but so far has stopped short of saying trades should migrate to exchanges.
The United States and the EU say clearing must be done locally so that authorities can access data on trades, which has led to several clearing services being set up on both sides of the Atlantic to ensure competition.
Some major players would like to save on collateral by using one clearer globally for all their trades and the BIS report said a plethora of clearers may not be beneficial.
So while a single CCP would almost surely reduce systemic risk relative to a bilateral OTC system, multiple CCPs may not... This might make it less attractive for market participants to move their trades to CCPs, it said.
(Reporting by Huw Jones; Editing by Victoria Main)