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.
Because of their flexibility, OTC derivatives bestow considerable benefits by allowing financial risks to be more precisely tailored to risk preferences and tolerances. They have contributed to the development of a more complete (and efficient) set of financial markets, improved market liquidity, depth, and breadth, and increased the capacity of the financial system to bear and price risk and allocate capital. As a result, OTC derivatives instruments, the structures for trading and risk-managing them, and the infrastructures for ensuring their smooth functioning play a central role in the performance of the major financial and capital markets. Overall, OTC derivatives activities have contributed significantly to the effectiveness and efficiency of the international financial system.
Along with these fundamental positive contributions, as crises in the 1990s have demonstrated, OTC derivatives activities can contribute to the buildup of vulnerabilities and adverse market dynamics in some circumstances. The severity of turbulence in the 1990s, and in particular the contours of the market dynamics in the aftermath of the near-collapse of the hedge fund Long-Term Capital Management (LTCM) in the autumn of 1998, suggest that OTC derivatives activities are capable of producing instability, in some cases akin to a modern form of traditional bank runs. The virulence of the 1998 turbulence in the mature financial markets took market participants and authorities by surprise, and some authorities have acknowledged that they do not fully understand the rapidly changing structure and dynamics of global financial markets. A substantial buildup in derivatives credit exposures and leverage contributed importantly to the turbulence. This substantial leverage—LTCM accumulated $1.2 trillion in notional positions on equity of $5 billion—was possible primarily because of the existence of large, liquid OTC derivatives markets.
In the wake of episodes of financial turbulence during the 1990s, much has been written about derivatives instruments and the role of highly leveraged institutions in international financial markets.1 By contrast, little has been written about how the increased reliance on OTC derivatives activities and market structures by the systemically important, internationally active financial institutions may have changed the nature of systemic risks in the international financial system. This paper attempts to fill part of this analytical gap, in part by building upon a broad overview of market practices, market structure, and official supervision and regulation in financial markets. Rather than exhaustively examine all details in these areas, this Occasional Paper highlights the key features of modern banking and 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 layout of the paper is as follows. In Section II, the paper describes how OTC derivatives activities have transformed modern financial intermediation. It 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. Section III outlines the structure of the OTC derivatives markets in its present-day form, describes some of the key elements of market practice, including trading and risk management, and highlights the key differences between organized-exchange and OTC markets. Section IV provides an overview of the regulatory environment for OTC derivatives activities and markets in key jurisdictions, with particular emphasis on how regulations affect the location and legal entities for OTC derivatives transactions and how regulatory uncertainties can affect OTC derivatives activities. Section V summarizes and distills the key features of OTC derivatives markets that have potential implications for systemic risk, and thereby provides analytical perspective on their functioning. Section VI concentrates on financial stability issues and identifies sources of risk to market stability and imperfections in the underlying infrastructure. Progress in addressing some of these risks and imperfections has been limited, and the next section identifies areas where further efforts are necessary if the risks of instability are to be reduced and avoided in the future. Section VII summarizes the main conclusions of the paper. An Appendix reviews the historical roots of the OTC derivatives markets.