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“mark-to-market” process. rough this process, when prices move in favor of a particular position, the holder of that position receives a cash payment equal to the price change times the size of the posi- tion; but when prices move against the position, the holder must make a cash payment determined using the same formula.

extend credit to the counterparty and not require daily marking to market. us, rms may prefer to trade OTC contracts, even if highly standard- ized, because they impose fewer cash ow risks and associated costs. is is a material consider- ation for many traders, and explains their prefer- ence for OTC products.

  • is mark-to-market process can be onerous for

some hedgers because it creates cash ow risks. For instance, consider a rm that has bought a cargo of oil that it anticipates selling in three weeks. e value of that cargo rises and falls with the price of oil, but the owner will not receive a cash ow until he sells it. us, day-to-day chang- es in the value of the cargo do not result in day-to- day cash ows. If he hedges that cargo by selling oil futures, changes in the price of oil will result in changes in the value of the futures position that will mirror changes in the value of the cargo, but importantly, will also result in cash ows on the day the price change occurs—but only on the fu- tures “leg” of the hedge. us, there is a mismatch between the cash ows on the thing being hedged (the cargo) and the hedging instrument (the fu- tures contract); the futures contract has (unpre- dictable) cash ows every day, but the cargo’s cash

  • ows occur on a single day.

  • is cash ow risk can be damaging to rms. For

instance, if the price of oil skyrockets, the owner of the hedged cargo will have to make a large cash payment on his futures position, but he will not receive the cash inow reecting the gain on the cargo until it is sold some days later. us, rms that use futures to hedge need to have access to sucient liquid capital to cover potential mark- to-market losses. is liquidity is costly for many

  • rms.

In contrast, OTC collateralization arrangements are much more exible. An OTC dealer may

In sum, there are good reasons why some traders prefer to trade OTC products as opposed to ex- change-traded ones. In particular, customization and more exible collateralization mechanisms make it more ecient for some rms to trade OTC contracts. Forcing trading onto exchanges would sacrice these eciencies.

C R

  • e regulatory scheme mandated by ACESA, and

by other proposals to restructure derivatives mar- kets, would permit rms to trade some contracts (though not carbon derivative contracts) OTC, but only if they are cleared by a designated clear- inghouse. is is also undesirable for a variety of reasons.

First, as noted above, the more rigid collateraliza- tion mechanism in clearing imposes substantial costs on some market users. Second, clearing is a risk sharing mechanism, and like any such mechanism, it can create incentive and informa- tion problems that generate costs that exceed the benets of risk sharing.

In a clearing mechanism, if one trader defaults on his contractual commitment, the clearinghouse is obligated to assume the defaulter’s obligation.13 But the clearinghouse is essentially a sharing mechanism. e clearinghouse is capitalized by its member rms, and these rms are obligated to make additional contributions to cover losses arising from the defaults of other members if


As noted before, clearing is actually more complex than this. See the references in footnote 2 for a more detailed description.




C A p - A N d -T R A d E :

E f f I C I E N T LY R E G U L AT I N G T h E C A R b o N d E R I VAT I V E S M A R k E T


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