Of course it is a "threaten" since a big portion is just non-covered speculative positions!!!!

RISK AND THREAT DIFFERENTIATED: We must make the distinction between risk and threat. The risk in this case is the risk of loss of the investment. Unlike the regulated market, i.e. stock exchanges, over the Counter (OTC) trading is outside of many tight regulations of the Security exchange Commission, i.e. security regulations, save some routine compliance issues of regular reporting. The risk is higher in OTC then in the regular market. The risk is the risk of lost of the investment borne by the investors (individuals and institutional investors).

The risk to investors of losing the principle of the investment is not the same as a "threat." Here, we would agree that the term threat is referred to the risk to the economy, i.e. macro-level risk. Does OTC carry such a risk to the economy----assume the worse case scenario that its collapses?

THREAT NOT SIGNIFICANT: The OTC market is more like a gambling house. Investment is made upon presentation of information that is not subject to state regulated and higher standard of scrutiny. Thus, these investments are indeed "betting game." Could it pose a threat to the economy? Not really for two reasons; (i) if it is large, it is too big to fail---assume such theory is valid, and (ii) a casino or a gambling house condition (success or fail) would not be a threat to the economy proper. We read these indices to gauge the health of the economies: NYSE, NIKKEI, HENG SENG, FTSE, NASDAQ, CAC40, etc. We do not read OTC index to assess the health of the economy.

SELF-REGULATED MARKET: A more somber rationale why OTC may not be a threat to the economy proper is that fact that OTC is a training ground for listing companies. These OTC issues could not meet the stringent guidelines of the conventional exchanges; therefore, they list themselves at OTC. After some years passed, these companies generally graduated to the big board in the conventional market and pave new issues to enter the OTC. This recycle process serves as an OTC self-regulating market. Thus, it cannot let itself fail.

Interesting analysis Paul! I agree on the principle of  distinction between Risk and Threat. In fact the Risk belongs to the Gambling part of the situation we are considering . I wonder if ,in the specific case, the book builders of the Banking System, are risking too much on their own, eventually, on the betting affair. If we revisit Lehman Brothers experience, the too big to fail principle  does not always work favourably,  as expected.And this concept,  belongs to the Threat part of the question! 

Effective next March, the ECB is injecting in the financial system of Europe about 60 Billions Euro per month in a huge operation of liquidity,  intended to favour the economic recovery . The mentioned  ECB , huge QE operation, is foreseen to end in September 2016.

Let me suppose that , in the meanwhile, from the $ side, the FED does not  start to raise the cost of money as presently expected and the European Banking system does not channel effectively to the economy side the additional financing mean (for investments and consumption),.

I would expect consequently that a possible Threat might arise for the possible jam up on the betting house, (hunting for speculative Yields) in presence of excessive liquidity in the system and low interest rates in the current money market. The possibility of a Threat to the Economy and System, would come out then in my opinion from the point outlined  by Carlos in his answer: the event of concentration of too many uncovered speculative  positions, generating a Lehman Brothers ("possible??")  revisited story !

Kind regards

Alberto

Paul, I'm going to have to disagree with you on this one.

The size and scope of the OTC derivative trades is just one of the problems we're confronting. The other problem we have is how dependent the largest players are on artificially cheap money (QE Eternity), and who's actually on the hook the next time one of these derivative gambling dens (a real daisy chain of bets) explodes. Let's start with EQ Eternity.

THE FALSE PROMISE OF QE ETERNITY: In real simple terms, no one should be jumping for joy over the S&P and the Dow hitting new highs. The records being set are artificial and based on taxpayer-backed money dumps from the Federal Reserve (then we have stagnating wages in the U.S., but let's save that for another day).

The correlation between S&P and the Dow hitting new market highs because of - and only because of - the Fed's interventions is clear.

For those who don't see it, here's what's happening (I've attached a chart below; I hope it's readable). Every time the Federal Reserve steps in and dumps money into the market (to purchase Treasury bills, European swaps, or to buy toxic market instruments) it puts enough money into the system that it pumps up both the bond and stock markets. When the Federal Reserve pulls back, not surprisingly, the market begins to stagger.

To be sure, as I've pointed out elsewhere, regular bailouts and favorable legislation are also helping to artificially pump up the market in the U.S. But the money dumps from the Fed seem to be what's putting the market into overdrive.

If you're wondering what this means let's make this real simple. Our markets are not healthy. They are entirely dependent on artificial stimulants - Fed money dumps, legislative favors, and bailouts - for their success. It's really that simple.

But, wait. There's more.

HYMAN MINSKY LIVES: We need to take another look at what Hyman Minsky told us about market players. Why? Because he reminds us what happens to economies when they are dominated by hedged investors (who can back their bets), speculative market players (who can find the money to back their bets), and the Ponzi or Pyramid market players who are just one step ahead of the next market collapse.

It’s not difficult to see which group of market players we were dealing with in the lead up to 2008 (and, make no mistake, they‘re still out there). I believe this is what Carlos R. Barrera-Chaupis is referring to with his "non-covered speculative position" comment above. And he's absolutely correct.

Now let's take a guess which kind of investors we're dealing with on Wall Street and in the OTC game today?

Making things worse, market players (or broker-dealers) in the United States are not only dependent on borrowing cheap money (the infamous "Greenspan Put") to make their market bets, but they're also borrowing money from clients whose portfolios they're supposed to be managing. And it's happening on a level that many Americans don't see, or understand. I'm not going to go into detail here (click on the link below for the story), but I will say that we have too many indebted and debt-sourced market players taking risks that they can't manage (or cover) - which includes the OTC and Wall Street market players (as the link below makes clear).

LOSS TO INVESTORS?: Finally, let me address the issue of "investors" losing out.

It's difficult for big market players to actually lose if they don't have to play by market rules that say if you made a stupid deal you have to pay the market price - insolvency or bankruptcy. Since the early 1980s - beginning with our "free market" President Reagan - the United States has been bailing out and subsidizing the biggest market players (and small time players too) in America on a regular basis. Whether it was 1982 (Mexico-Wall Street), 1989-1992 (the Savings & Loan debacle in the U.S.), 1994 (Mexico-Wall Street, again), 1997-98 (Asia-Wall Street; Long Term Capital Management), and of course, The Mother of All Bailouts, in 2008. 

What I'm trying to say, Paul, is that we can't argue as if we are living in a market environment where the levers of the market work efficiently. They don't. 

At the end of the day, we are dealing with a system that is in danger because it is exposed to both systemic risk (tied to the political incompetence in Washington DC, especially with the constant budget games) and financial risk (when market players don't have the money to back their bets). 

There's more, but I think you get the point. We have a mess on our hands. Dodd-Frank fixed nothing. So, yes - to answer Alberto's question - the present OTC levels are a macro economic threat. 

- Mark 

http://markmartinezshow.blogspot.com/2012/01/wall-streets-doing-it-again-part-ii-our.html

Dear Mark,

I entirely agree with you. The problem will become acute as soon as hot money evaporates. That's best described in the Minkovsky space how suddenly "strong" trends break and crashes follow when liquidity disappears. We have seen a harbinger already. On January 15 EURCHF crashed in the matter of a few minutes leaving a lot to think what were HFT funds doing then, actually why they disappeared from the market like the Chinese Wall in a Copperfield's trick? Prepare for the worst, the best will take care of itself. Quite recent developments on DJIA show that when the market is purposefully left by big hands to the public for a sentiment test, the index goes down quite fast. People do not give trust to the present uptrend which began from the lows of 2009. Is it supported by some crutches? I am of the opinion that we may have some new legislative initiative disallowing large leveraging when things start looking very nasty and provided there is someone who can imagine even the worst possible meltdowns underway. After all, what do you think about reducing the financial risk by onetime forced change of leveraging rules applicable to all uncovered open positions? The public would cheer to the idea and hail the saviors. I think that financial engineering tools will be considered sooner than later. Catastrophies deferred like deferred payment.

Regards

Paul     

https://www.bis.org/publ/othp20.pdf