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January 2010


Both the U.S. House of Representatives and the U.S. Senate have drafted financial reform legislation prompted by the financial market failings the country experienced in 2008. Both versions provide for comprehensive regulation of the OTC derivatives products, which were used extensively by those financial institutions that lost millions of dollars from investments in mortgage securities to insure against subprime mortgage defaults. This paper discusses the efficiency of proposed Congressional legislation to regulate the Over-the-Counter (OTC) derivatives market in light of the provision in the legislation that effectively exempts customized OTC derivatives contracts from clearing requirements and exchange trading. The exemption allows OTC derivatives dealers trading customized contracts to continue trading in the same opaque markets in which they engaged in rent seeking behavior that almost led to the collapse of the financial markets. The manuscript discusses why Congress has proposed these exemptions, why the exemption creates economic inefficiencies, and calls for Congress to devise a definition for customized OTC derivatives contracts to narrow the definition of what constitutes a customized trade to ensure that OTC derivatives dealers are not allowed to intentionally craft their OTC derivatives contract to avoid clearing and exchange trading requirements.

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