Second, the bilateral nature of the OTC derivatives market – between the two parties to the contract – be it dealer and customer or dealer and dealer – created its own set of difficulties. When counterparties became concerned about the health of a particular dealer, they often moved their trades – via novation – to other dealers. They did this to protect themselves should the dealer subsequently fail. But this process was difficult to carry out quickly and in size. The cumbersome nature of the process disturbed market liquidity and function. It also tended to drain off the liquidity from the troubled dealers because these dealers often used the counterparty cash collateral to fund their own operations. When customers moved their  BIS central bankers’ speeches  1  business, the collateral balances departed with them and this worsened the funding crunch on the troubled dealers. Third, when a large counterparty, Lehman Brothers, filed for bankruptcy, it could no longer meet its obligations. The claims of Lehman’s customers, including those open OTC derivatives positions in which Lehman owed them money, were frozen. The lack of adequate segregation of the customers’ assets from the Lehman estate and the inability to move the outstanding obligations to other dealers – which we refer to as the lack of portability – created large problems for Lehman’s counterparties. Often Lehman’s clients were in the position that one side of a trade executed with Lehman was frozen, but the offsetting side remained open and exposed to volatile financial markets.
Among these potential mechanisms, particular importance was accorded to the so-called “competitiveness channel”, which works as follows: when an economy’s inflation rate stands systematically above the average for the rest of the area, the very loss of competitiveness involved – or, what amounts to the same, the relative rise in the cost of output in that economy – tends to reduce demand-side pressures and ease the tensions on prices that led to the initial slippage. However, for this channel to work economies should, inter alia, be adaptable and sufficiently flexible, something which, for social and political reasons, is evidently not easy to achieve. It was also thought monetary union membership would prompt greater discipline in economic policy management. It was assumed that, if a Member State’s management of the economic instruments available to it was inadequate, the subsequent adverse effects on its growth and employment-generating capacity would lead international investors to demand greater returns for investing in the country, or even to freeze such investment. The subsequent tightening of financing conditions would discipline economic agents and ultimately redress economic management. But this mechanism did not work because financial markets, rather than punishing divergences, instead financed excesses, contributing to exacerbating tensions. Unsurprisingly, then, the crisis has called into question the consistency of the institutional arrangements underpinning the euro. The solution would involve a reformulation of the initial project, geared to fuller integration.