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Exchanges, OTC Derivatives, DPCs and SPVs

4 important questions on Exchanges, OTC Derivatives, DPCs and SPVs

What about OTC derivatives?

Exchange is easy accesible, transparant and has a wide range of participants. OTC is arranged bilaterally and closing out is not easy. However, OTC allows for tailored products. Note that customised is not equal to exotic OTC derivatives that might disturb market efficiency. In general OTC is more useful as a risk management tool, due to tailoring the basis risk can be decreased. But as said unwinding is difficult and OTC lacks fungibility.

What about market development?

IR products biggest component but misleading in terms of risk as in an IRS the notional is not exchanged while it is in a FX swap and CDS. Moreover, exchanges are measured in terms of open interest or net positions whereas OTC generally refers to gross positions. In addition, OTC usually has longer-dated products.

Regarding risk consider 'wrong-way' risk as well in terms of CDS; when market goes down and you bought protection the counterparty risk increases and likelihood of not getting paid the notional increases. To prevent further risk periodic cash resettlement might be useful.

What about Counterparty risk mitigation in OTC markets?

Prevent initial spark to happen or the exploding effect the spark will have (flammables). Most firms focus on the former, although balancing it with the need to grow and prosper. SPVs and DPCs were used to controlling inherent counterparty risk.

WHat about monolines and CDPC?

A default remote entity. CDPC is an extension of DPC to credit derivatives. Typically didn't have to post margin in normal times against MtM declines due to their excellent rating. Lot of rating were withdrawn during the crisis.