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A Theory of Market Design: The Split Market Paradigm.
James Kurt Dew1
Tecnológico de Monterrey, Querétaro
Abstract: Before the market events of the early 1970’s, financial markets generally were
split into two parts, price-risky and price-stable. This largely subconscious division served
the financial world well. Price risky portfolios were accounted for on a mark-to-market
basis, and exchange-traded, where liquidity warranted. Price-stable instruments were
accounted for on a deferral basis and rarely traded. The markets performed their function
without incident between World War II and 1970.
This split market paradigm was broken by the post-1970 introduction of OTC instruments.
Had the paradigm been preserved and the markets’ split retained, there would have been no
second, man-made, contribution to market risk and perhaps no series of disasters that
culminated in the Financial Crisis of 2007 (hereafter Crisis).
The article describes trading technology that could reinstate the split market paradigm.
The Introduction describes the split market paradigm. Section Two shows the costs of
violating it. The third section describes a means of restoring it. The final section concludes.
“Perhaps science does not develop by the accumulation of individual discoveries and
inventions.”
- Thomas Kuhn.
1. Introduction:
In the early 1970’s, a stable system of trading, clearing, and portfolio management was
fractured by the dramatic increase in market risk resulting from a series of perhaps related
events: the collapse of the Bretton Woods Agreements, the end of Texas Railroad
Commission-dominated oil pricing, and inflation-induced increases in dollar interest rate
volatility, that ultimately ended the Fed’s Regulation Q limits on bank interest rates. Here
these events will be called, collectively, the Collapse.
1
The views expressed are the author’s and do not necessarily reflect the views of Tecnológico de Monterrey.

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A model of ideal market structure, the “split market paradigm,” refers to any system that
separates accounting, trading, and instruments into a price-stable component and a price-
volatile component. Before the Collapse, investments either originated and remained in
price-stable portfolios, or originated and remained in price-volatile portfolios. Accounting
rules, properties of the instruments, and their trading venues differed, each system efficient
in its own risk environment. This split market system worked without mishap from the end
of World War II until the Collapse.
The split market paradigm is a useful devise for considering what went wrong when OTC
instruments were first introduced after the Collapse. The market phenomenon that the
Collapse created was greater price risk. Enough so that many formerly price-stable
instruments became price-risky. The OTC instruments that were developed after the
Collapse to mitigate the new price risks might have been successful if the importance of
retaining the split between asset types had been understood then.
2. The Muddling of the Two-Market Split.
The OTC financial instruments designed after the Collapse added man-made risks, because
they did not preserve the split market system. Instruments designed to function in a price-
stable environment were allowed to migrate into the price-risky environment without
appropriate modification.
While the risks stemming from the Collapse cannot be altered or changed, only moved; the
need for man-made OTC risk might be beneficially examined. OTC credit risk that
migrated to price-risky portfolios has proven disastrous during the Crisis and unnecessary.

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OTC instruments were first designed to meet the needs of corporate hedging customers
being savaged by their once price-stable assets and liabilities, and continue to meet these
needs admirably in the price-stable portfolios for which they were designed.
But the importance of maintaining the split market system was not understood. There was
little consideration in new OTC instrument design for performance of the new instruments
in the dealer-to-dealer trades made in the after-market, or for the accounting and risk
performance of dealer portfolios containing the new instruments.
In the OTC securities and derivatives markets this lack of attention, if understandable, has
proven disastrous. OTC instruments produce cosmetically stable income in deferral
accounting environments, but in the process add otherwise undesirable credit risk.
If separate OTC financial instruments and trading practices, adapted to mark-to-market
environments, had been designed at the outset, the split system would have remained intact;
and portfolios safer and simpler.2
To complete the markets and return to the split market
system, price-risky environment analogs to OTC instruments might be beneficial.
Non-negotiability, appropriate in untraded price-stable portfolios, is anathema to efficient
portfolio management in price-volatile environments. It balloons bank balance sheets.
Credit risk is multiplied when the holder of an OTC position wishes to exit. The only
practical way to do so is to assume an equal and opposite position, thereby doubling the
bank’s credit risk in order to reduce price risk.
2
Awrey, D., 2011, “Complexity, Innovation, and the Regulation of Modern Financial Markets,” Harvard
Business Law Review, vol. 2, p. 243. As Awrey points out, “…the vast majority of the complexity—and thus
the information costs and bounded rationality—within modern financial markets does not emanate from
within the relatively transparent (and static) public markets for capital”

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The old OTC instruments’ undesirable credit risk reduces price-risky portfolio values; their
complexity obfuscates price-risky financial reports. The dealer market has become opaque,
complex, and unnecessarily risky.3
As a result OTC instruments have gone from being the solution to the key problems of
financial management to being the problems themselves.
The Dodd-Frank mandate to clear through OTC CCPs is a symptomatic treatment of the
OTC credit risk disease.4
But the mandate to form and manage CCPs that clear these
instruments did not include a possible cure – it did not include designing the OTC
instruments themselves to be exchange-compatible or even price-risky portfolio
compatible. An OTC square peg was forced into a futures exchange round hole. The result
is that a CCP is a very large counterparty, not a futures clearing house.
This distinction is made because CCPs have exposure to long term credit risk, the
underlying OTC instruments’ disease, unlike futures exchange clearing houses. There are
many problems introduced by this fact.
 The most obvious effect of the excessive risk of CCPs is the negative market valuation
of a CCP’s portfolio. The CCPs have one property in common with stock and futures
exchanges – they have bought and sold only matched pairs of long and short
counterparty positions at the same market price. But the similarity ends there. Unlike
bankrupt participants in futures markets, bankruptcy of a CCP’s counterparty does not
permit the CCP to end its exposure to that counterparty. Thus both sides of every CCP
position, long and short, present credit risk to the CCP.
3
Cohn, G., 2015, “Clearing houses reduce risk, they do not eliminate it,” Financial Times, June 22, 2015.
4
An OTC CCP is a futures exchange-managed central counter-party that steps between each of the parties to
every inter-bank dealer OTC derivative trade of significance.

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Since the expected payments from both long and short are equal and opposite, credit
risk is the only part of expected payments of a long/short pair that affects CCP net
present value, and the effect is negative for the combined counterparties. In other
words, the total market value of each pair of CCP positions must be negative.
Stock and futures exchanges are a zero sum game; OTC derivative CCPs, a negative
sum game.
 Historically prices of exchange-traded securities and futures were determined by the
market, not the exchanges.5
Prices of OTC instruments on CCPs, while based on an
underlying “baseline” market transaction in most instances, are in fact CCP-determined.
There is never a market test, since the instruments cleared are heterogeneous. The CCPs
do not identify a limited number of acceptable instruments, but instead clear the entire
generic instrument class, as required by regulation. The result may be untenable
systemic risk, particularly with less homogeneous, illiquid instruments.
 CCPs have, in principle, the same rule of offset as futures, but not in practice.6
While
the offset rule applies within the CCPs, since the CCPs cannot limit the contract terms
of OTC trades, traders rarely actually have identical offsetting positions.7
Left unaddressed by the Dodd-Frank clearing mandate was the relationship between
instrument clearing and instrument liquidity. For the exchanges existing before Dodd-
5
It might be argued with growing veracity that the statement that futures prices are market determined ceased
to be accurate when cash settlement was permitted in the S&P 500 and Eurodollar futures contracts. The
argument made by the Exchange to the CFTC, when both contracts were submitted, that the publicly available
market price of the instrument on the settlement day was a report of actual transaction prices, has been proven
dubious in the case of the S&P and flat wrong in the case of Eurodollars. The issue has been greatly
compounded as new contracts in increasingly illiquid markets with cash settlement rules are now routinely
CFTC-approved. This continues in spite of the disastrous effects of cash settlement in the cash markets for
LIBOR and Foreign Exchange, in the Fixing debacles.
6
The rule of offset is this: if an exchange counterparty has bought and sold an identical commodity, the
counter-party has no position.
7
The CCPs attempt, perhaps dangerously, to reduce the margining of positions based on correlations between
position prices to approximate the benefits of offset.

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Frank, the issue was economic. Exchange economics, driven by economies of scale,
dictates that only the most liquid instruments are successfully exchange-traded.8
The
argument can be made that if OTC market participants had considered the economics of
trading to be paramount, the issue in OTC trading would also have been decided on the
economics, without a near-fail during the Crisis. But the dealer banks closed that option by
clinging to their joint market monopoly, ultimately forcing the government’s hand.
Cohn4
recommends considering market liquidity when choosing to clear each OTC
derivative instrument. He describes the difference between OTC markets whose risk is
reduced through clearing and those whose risk is increased in liquidity terms as follows:
“Clearing works best in the case of standardised products that trade in deep and
liquid markets — and when clearing houses are backed by strong capital
structures and robust risk-management capabilities. In these conditions,
clearing can lower counterparty risk, reduce interconnectedness among banks
and improve price transparency.
Yet in other markets, clearing houses can themselves become centres of
concentrated risk and sources of contagion, amplifying systemic problems
instead of alleviating them. They are particularly unsuited to complex, illiquid
products that are susceptible to sudden and severe price gaps. Forcing central
clearing on such markets can have serious repercussions.”
Once the liquidity test proposed above has been conducted,9
price-risky asset-consistent
trading and clearing methods can be implemented. An efficient system for the trading and
clearing of liquid assets would be designed to trade, clear, and price all markets in each
instrument identified.
8
The principle of offset, in particular, drives clearing business to a single market.
9
In practice, exchanges list everything under the sun. The market ultimately decides the issue of liquidity.

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3. A Consistent System for Price-Risky Asset Management.
A few changes make it possible to trade liquid OTC derivative instruments of systemic
importance on cash/futures exchanges or alternatively in dark pools, thereby dramatically
reducing systemic risk. These instruments are not only less risky but far simpler, producing
greater ease in risk measurement and management, benefiting both the investor/consumer
of financial institution financial reports and the taxpayer protected by bank regulators.10
Combined with changes to OTC cash and futures instruments,11
they make it possible to
trade every OTC instrument along with its associated futures contract on a single universal
trading and clearing platform.
In other papers we propose designs for cash and futures trading12
and for OTC derivatives
clearing.13
The basic principles upon which the price-risky trading system is based are:
 Measures to reduce credit risk through more frequent offset.
a. Eliminate superfluous waiting between determination of payment amount
and payment. Waiting creates unnecessary credit risk and mark-to-market
prices that must be exchange-determined, not market-determined.14
10
Since they are not futures contracts but use the same trading technology, and since the underlying cash
markets are not SEC regulated, they appear to be available for listing by dark pools, perhaps with less red tape
than an exchange would require.
11
These are described in detail in Dew, James Kurt “A Fix for the Unnecessary, Undesirable, Over-the-
Counter (OTC) Dealer Markets.” May 23, 2015, http://ssrn.com/author=511466 , last accessed on July 22,
2015,
12
Dew, J. K., “A Fix for the Unnecessary, Undesirable, Over-the-Counter (OTC) Dealer Markets.” August 2,
2015. Available at SSRN: http://ssrn.com/abstract=2609454
13
Dew, J. K., “FFDs: Futures Friendly Derivatives That Replace OTC Cleared Derivatives.” August 3, 2015.
http://ssrn.com/abstract=2609438. This article shows how an OTC derivative can be replaced with a futures-
style trading instrument. Last accessed on August 3, 2015.
14
An existing OTC instrument, the Forward Rate Agreement, already addresses this problem by paying
present value of payments at the time the payment amount is determined.

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b. Synchronize payment dates so more instruments related through a single rate
basis such as LIBOR offset each other exactly.
c. Trade cash instruments in constant multiples of $1 million, using a clearing
system to combine and divide odd lot deposits as necessary.
 Measures to improve price discovery and secondary market access.
a. Use these cash deposits to settle futures contracts.
Any OTC instrument that makes these adjustments can be exchange-traded as a deposit, a
futures friendly derivative (FFD) or to settle a futures delivery, eliminating the need for
OTC CCPs in liquid markets.
The desirability of listing only the liquid instruments of the market may be a telling
disadvantage to the regulated markets, which are subject to the government mandate to
clear all of the instruments in a given derivative class. This may give unregulated markets
an advantage, since they may list what they choose.
4. Conclusion.
The financial instruments that have been with us for more than a century: untraded (loans
and deposits) and traded (stocks, bonds, and futures) still perform their functions
admirably. It’s the instruments created since 1970 that are inefficient. And they all have the
same inefficiency – their function can be performed with much less credit risk in secondary
markets.

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The goals we propose of any adjustments to instruments created post-Collapse would be to
create two conditions:
1. All liquid markets are traded on futures or stock exchanges or dark pools, with their
implied risk protection and price discovery.
2. Markets, not committees, decide prices of liquid instruments.
Adjustments needed to foreign currency and Eurodollar markets to achieve these ends may
require consideration of issues with trading technology. Evidence for this position stems
from the performance of the flagging US domestic certificate of deposit (CD) market, and
the defunct CD futures market.
Elsewhere, the author argues that there are problems associated with current market trading
of negotiable deposits that may be reduced by using some of the methods of US Treasury
trading. Much may be done commercially to improve the usefulness of the Eurodollar
deposit market – more than to simply make Eurodollar deposits negotiable.6