Is the OTC Market a Market Failure? Derivatives from the Perspective of Transaction Costs

The neoclassical economics regards derivatives as the necessary instrument providing not only liquidity or risk spreading, but enabling the existence of the perfectly competitive market, since without derivatives there is no possibility to meet one of the core requirements of the General Equilibrium Theorem - the complete or contingent contract claim, according to which there should be the market for any possible state of affairs. On the level of law and economics the issue arises whether derivative law and massive stock and future exchange regulation leads to the zero transaction costs micro worlds and global market of markets. A drive toward dualism might be observed: regulated futures, stock and commodity exchange (with almost no litigation, due to technical regulations; deposits, clearing house, licenses, etc.) or sophisticated conventions (OTC market) are present on this market rather than typical contracts. The derivative OTC markets are regulated by soft law enforced in non-jurisdictional way. The paradox lies however in a fact, that derivatives work efficiently within a perfect competitive market structure, whose existence is conditioned upon the effective work of derivatives. As R. Coase observed many years ago, economists very often behave as if we lived in an ideal world of zero transaction costs, or to put it differently, within a world of perfect competitive market economy (Coase, 1990). Unfortunately not all derivative markets are perfectly competitive and arguably there are not always zero transaction cost worlds. The normative Coase theorem suggests that the regulation and judicial decision should pursuit efficiency and diminish transactional costs (Coase 1988). Additionally Coase suggests that the regulatory framework diminishes the level of transaction costs. If it is so, what is the function of the OTC derivatives’ market? Why the regulated market did not supersede the OTC market, even if statutory and judge made law in many jurisdictions aimed at eliminating the OTC market?