The weakness of OTC

On 16 Sep 2008, AIG had to borrow US$85billion worth of loans from the Federal Reserve as its attempts to obtain loans from other financial institutions and raising cash through stock sales failed.

How could AIG face such liquidity crunch? The answer, is mainly the credit-default swaps that AIG is liable to make payouts for. ("Fed Agrees to Lend A.I.G. $85 Billion to Head Off Crisis", by Edmund L. Andrews, The New York Times, 17 Sep 2008)

What could have been done to avoid such liabilities concerning these Over-The-Counter derivatives? These OTC should not be OTC in the first place. They should be traded in an exchange where the buyers and sellers are the market makers. There should not be brokers in the market acting as the market-makers. Yes it might reduce the potential trading liquidity for these OTC swaps, but there will be reduced risk as brokers do not have to take an extended position for 1 side of the OTC swaps.

Brokers if they are market-makers of OTC swaps, could be in AIG shoes, taking on too much of 1 position that would cause huge liabilities to themselves. These liabilities would become too much to bear that a crisis would occur.

The present scenario would be for the Securities Exchange Commission to take an immediate stance and create an exchange for derivative instruments that have been trading as OTC. This would reduce counterparty risk for buyers and sellers as they would be dealing with themselves. Should they deal with just 1 financial institution, they would face the default risk of the financial institution, aka AIG in this case.