Browse

You are looking at 1 - 9 of 9 items for :

  • Occasional Papers x
  • Investments: Options x
Clear All
Mr. Burkhard Drees, Mr. Garry J. Schinasi, Mr. Charles Frederick Kramer, and Mr. R. S Craig

Abstract

The rapid growth, development, and widespread use of over-the-counter (OTC) derivatives have accompanied, and in many ways made possible, the modernization of commercial and investment banking and the globalization of finance. OTC derivatives instruments and markets have developed rapidly along with the emergence and evolution of the internationally active financial institutions that presently intermediate the bulk of international capital flows and capital in the major financial markets around the globe. These and other financial structural changes would not have been possible without the dramatic advances in information and computer technologies that have occurred during the past two decades.

Mr. Burkhard Drees, Mr. Garry J. Schinasi, Mr. Charles Frederick Kramer, and Mr. R. S Craig

Abstract

During the past two decades, the large internationally active financial institutions have transformed the business of finance dramatically. In doing so, they have improved the ability to manage, price, trade, and intermediate capital worldwide. Many of these benefits have come from the development, broadening, and deepening of, and greater reliance on, OTC derivatives activities (see Box 2.1: Precision Finance, Desegmentation and Conglomeration, and Market Integration). Although modern financial institutions still derive most of their earnings from intermediating, pricing, and managing credit risk, they are doing increasingly more of it off balance sheet, and in less transparent and potentially riskier ways. This transformation has accelerated during the 1990s.

Mr. Burkhard Drees, Mr. Garry J. Schinasi, Mr. Charles Frederick Kramer, and Mr. R. S Craig

Abstract

This section provides an overview of OTC derivatives markets, with particular emphasis on those aspects that are relevant to an assessment of systemic financial risks. It begins with a description of the size and global scope of derivatives markets and the major participants and counterparties in OTC derivatives markets. It then compares the structures of exchange-traded and OTC markets, and concludes with a discussion of the trading and back-office infrastructure and the middle-office risk management functions for OTC derivatives trading.

Mr. Burkhard Drees, Mr. Garry J. Schinasi, Mr. Charles Frederick Kramer, and Mr. R. S Craig

Abstract

Although OTC derivatives on the whole tend to be lightly regulated (as noted in Section III), regulatory systems that are relevant for OTC derivatives can be complex and can have identifiable effects on the organization and location of OTC derivatives activities. Because OTC derivatives transactions usually involve sophisticated counterparties and OTC derivatives markets provide only a limited price discovery function, investor protection and related regulations play only a minor role in the official oversight of the OTC derivatives market. The other two traditional rationales for financial regulation—fostering market efficiency and reducing systemic risk—are important for OTC derivatives markets and are usually addressed by prudential regulations that typically apply to institutions as a whole and not to specific OTC derivatives products. This section illustrates these issues by reviewing the regulatory environments in key jurisdictions. It then analyzes the effects of regulation and regulatory uncertainty on OTC derivatives activities. The section concludes with a discussion of the key challenges for supervision and regulation associated with the use of credit derivatives.

Mr. Burkhard Drees, Mr. Garry J. Schinasi, Mr. Charles Frederick Kramer, and Mr. R. S Craig

Abstract

This chapter provides an overview of market practices, market structure, and official supervision and regulation in financial markets. This paper also highlights the key features of modern banking and over the counter (OTC) derivatives markets that seem to be relevant for assessing their functioning, their implications for systemic financial risks in the international financial system, and areas where improvements in ensuring financial stability can be obtained. The paper also describes how OTC derivatives activities have transformed modern financial intermediation and discusses how internationally active financial institutions have become exposed to additional sources of instability because of their large and dynamic exposures to the counterparty (credit) risks embodied in their OTC derivatives activities. In order to rebalance private and official roles, it is essential first to clarify the limits to market discipline in OTC derivatives markets, before leaning more heavily on aspects of market discipline that seem to work well in these markets.

Mr. Burkhard Drees, Mr. Garry J. Schinasi, Mr. Charles Frederick Kramer, and Mr. R. S Craig

Abstract

Against the structural and institutional background laid out in the previous sections, it is useful to step back and distill some of the key features and characteristics of OTC derivatives instruments, markets, and infrastructures. Ten such features can be identified that together convey the basic elements of modern banking and OTC derivatives activities and markets that are important for assessing market functioning, drawing implications for systemic financial risks, and identifying areas where improvements for ensuring financial stability might be obtained. The first two features address the risk characteristics of OTC derivatives and illustrate that OTC derivatives contracts are credit instruments that embody other risks, and that they can be used to unbundle, transform, and manage risk exposures. The next four features relate to the structure and operation of the markets, including the intermediation role of institutions active in these markets, the interbank/interdealer nature of the markets, the relatively high concentration of trading and counterparty risk exposures, and the central role OTC derivatives instruments and markets have come to play in other financial markets. The seventh and eighth features characterize OTC derivatives as vehicles that influence market liquidity and leverage. The last two features reflect characteristics of OTC markets that pose challenges for assessing and controlling both private and systemic risks, namely that OTC markets are relatively less transparent than other markets, and that they have become increasingly systemically important.

Mr. Burkhard Drees, Mr. Garry J. Schinasi, Mr. Charles Frederick Kramer, and Mr. R. S Craig

Abstract

As noted in the previous sections, some of the features of OTC derivatives contracts and markets that provide benefits and enhance efficiency either separately or jointly embody risks to financial market stability. OTC derivatives activities are governed almost exclusively by decentralized private infrastructures (including risk management and control systems, private netting arrangements, and closeout procedures) and market-disciplining mechanisms. By comparison, the more formal centralized rules of exchanges protect the stability and financial integrity of the exchange. In addition, the major financial intermediaries in OTC derivatives markets have access to financial safety nets. Because this can affect their behavior, they are required to adhere to prudential regulations and standards in the form of minimum risk-adjusted capital requirements and accounting and disclosure standards that inform financial stakeholders and to some extent support market discipline. The financial industry also has its own standards and best practices promulgated by various industry groups.

Mr. Burkhard Drees, Mr. Garry J. Schinasi, Mr. Charles Frederick Kramer, and Mr. R. S Craig

Abstract

Market participants and officials acknowledge there are problems, if not instabilities, and weaknesses in OTC derivatives markets, and proposals and initiatives have been advanced. Some progress has already been made, and the lessons of recent experience are likely to motivate further actions. However, the available evidence suggests that many recognized problems have yet to be adequately addressed. Insufficient progress has been made in implementing reforms in risk management, including counterparty, liquidity, and operational risks.103 Relatively less attention has been focused on removing legal and regulatory uncertainty. Given the limited progress to date, it is essential to implement changes to reduce market instability.

Mr. Burkhard Drees, Mr. Garry J. Schinasi, Mr. Charles Frederick Kramer, and Mr. R. S Craig

Abstract

Derivatives markets are central to the functioning of global financial markets, and both exchange-traded and over-the-counter derivatives have improved the pricing and allocation of financial risks significantly. OTC derivatives—compared with exchange-traded derivatives—are flexible and innovative. The ability to use them to unbundle financial risk into separate components is an important step in the direction of creating more complete and efficient financial markets. OTC derivatives enable economic agents to define more precisely their risk preferences and tolerances, and more effectively to manage them. These instruments and the markets in which they are traded support the pricing, trading, risk management, and market conditions in all the major bond, equity, and foreign exchange markets. Probably for this reason alone, they are systemically important, but these markets are also comprised of the internationally active financial institutions that intermediate a large share of international capital flows, and also the lion’s share of global lending, underwriting, mergers and acquisitions, and trading businesses. In effect, the OTC derivatives markets are composed of a complex network of bilateral, asset-price dependent counterparty exposures that intimately bind the world’s largest and most internationally active financial institutions in a very active and fast-paced trading environment at the core of the international financial system.