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Why foreign exchange transactions did not freeze up during the global financial crisi

Discussion in 'General Investing Discussion' started by Tropo, 24th Sep, 2010.

  1. Tropo

    Tropo Well-Known Member

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    Why foreign exchange transactions did not freeze up during the global financial crisis: The role of the CLS Bank

    Administration officials have once again put the need for new trading systems for complex derivatives on the front burner.
    Officials are right to be concerned, as many new financial products represent contracts between two counterparties – banks, brokerage houses, insurance companies, and hedge funds, among others – without the benefit of a centralised exchange or clearinghouse.
    These bilateral deals develop in a “shadow banking system.”
    When institution A trades with B and institution A’s credit standing takes a hit, there is a direct impact on institution B.
    But there is a follow on impact on C and D (who trade bilaterally with B) and on E and F (who trade bilaterally with C and D), and so on.

    It is well known that organised futures and option markets utilise a well-capitalised central clearinghouse and a mark-to-market convention that imposes a daily discipline on traders and prevents credit events at firm A from cascading onto firms B, C and D.

    A famous illustration was in 1995 when Nicholas Leeson, a 28-year-old trader at Barings Brothers, lost $1.4 billion trading Nikkei index futures.
    The losses drove Barings (a 228-year-old institution and “Banker to the Queen”) into bankruptcy, but that did not threaten the market or any counterparty.

    Far less well known is how the historic practice of bilateral trading (and bilateral clearing and settlement) posed a huge risk for another giant international financial market – the foreign exchange market – and how a new private institution (the CLS Bank) developed to counteract these risks and protect the foreign exchange market even in the face of a global financial crisis like the one we are now experiencing.

    The story is instructive in revealing not only how critical the new institution is to the steady operation of the foreign exchange (FX) market but also how long the process of developing something comparable for complex derivatives might take.
    more .... The clearinghouse that saved foreign exchange trading from the crisis | vox - Research-based policy analysis and commentary from leading economists