liquidity managing cash flow OTC Exchange systemic risk

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17 Nov 2010

“Search and matching” theories by Dr Alex Pilato

The lack of competition increases funding and hedging costs for borrowers, which in turn has a direct negative effect on economic growth. The ‘product bundling’ approach used by banks to reduce competition also has the effect of reducing risk and return (i.e. price) transparency on lending and OTC derivatives, which in turn restricts the efficiency of markets by preventing end users (such as corporates or pension funds) from entering these markets. Only very large and sophisticated investors and end users have the sufficient structuring and analytical skills to be able to disentangle these bundled products in order to ascertain the true price levels that a market can offer them. If other investors and end users are not attracted to a market because the little credit that clears does so at opaque levels (e.g. because the returns are not made on funding but on the associated OTC derivatives), then the financial markets will remain in crisis.

The search and matching theories that won three economics Nobel Prizes this week, show that it is not enough to have buyers and sellers who can in principle agree on a price if they are not able to find each other and decide to enter into a transaction rather than hold out because of disproportionate transaction costs relative to size and nature of the transaction. Other than for shorter term plain vanilla markets, supply and demand for OTC derivatives are currently matched inefficiently by banks. The authorities should facilitate exchanges where end users search and match other end users without the “friction” brought by banks.

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