Describe the systemic threat posed by OTC derivatives to the financial system. What kind of regulations would you advocate?
The Over- the-counter (OTC) derivative market is the largest market for derivatives, and it is estimated that its value in 2013 reached a level of 700-800 billion dollars, i.e. at least a dozen times more than the GDP over the world. The OTC financing contributed to bankruptcy of Lehman Brothers Holding Inc. in 2008 and Barings Bank in 1990s. Currently, just five banks control 90% of all derivatives contracts, so companies are allowed to gamble on deals made on financial sector. Therefore OTC markets counterparty default risk generates a network of interlinkages and interdependencies among market participants, promotes volatility and lead to systemic risk [Ghouri]. That means the failure of a ...view middle of the document...
The major risk of OTC derivatives can be party avoided by the creation of central clearing counterparties (CCPs) [Singh] and product standardization. In that way central banks or other repositories, to which the parties are required to report open positions and their valuation, will regulate CCPs. What is more the obligation to provide a security deposit by market participants should be implemented. The security deposit would protect against the risk of counterparty default. If there would not be unsecured exposure in the financial system it will decrease systemic risk. Since OTC transaction are not presented in the balance sheet, it might be crucial to subjected them to mandatory disclosures as the parties should be able to judge counterparty risk. The last suggested regulation refers to managers and investors salaries. Very attractive and system of compensation which is directly related to the generated return is a grater incentive for managers to take risk [Rajan]. Therefore it is suggested to launch policy, which will avoid excessive risk-taking.
Michie, J., Grieve, J., Derivatives - a Growing Threat to the International Financial System, in: “Managing the Global Economy”, Oxford University Press, New York, 2000.
Raghuram G. Rajan, 2005, Has financial development made the world riskier?, Proceedings, Federal Reserve Bank of Kansas City, issue Aug, pages 313-369.
Ghouri, A., 2010, The Law and Regulation of OTC Derivatives: An Anglo-American Comparison and Lessons for Developing Countries, Nordic Journal of Commercial Law, http://works.bepress.com/cgi/viewcontent.cgi?article=1002&context=ahmad_ghouri [access: 19.09.2013]
Singh, M., Collateral, Netting and Systemic Risk in the OTC Derivatives Market, http://www.imf.org/external/pubs/ft/wp/2010/wp1099.pdf [access: 20.09.2013]