II Modern Banking and OTC Derivatives Markets
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Mr. Burkhard Drees
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Mr. Garry J. Schinasi
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Mr. Charles Frederick Kramer
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Mr. R. S Craig
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Language:
English
Print Publication Date:
09 Jan 2001
Keywords:
OP; market; OTC derivatives market; derivative instrument; derivative; University Officers' Training Corps; credit exposure; derivatives position; OTC derivatives exposure; OTC derivatives activity; Securities markets; Derivative markets; Asset prices; Global
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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.

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.

The Transformation of Global Finance

Traditional banking involves extending loans on borrowed funds (deposits) of different maturities. Each side of this ledger has different financial risks. A simple loan is for a fixed sum, term, and interest rate; in return the bank is promised a known schedule of fixed payments. The risk in lending, of course, is that the borrower may become unable or unwilling to make each fixed payment on schedule. This is credit (or counterparty) risk,2 comprising both the risk of default (missing one or all payments) and the expected loss given default (that less than is promised is paid). Loans are funded by deposits with much shorter maturities than most bank loans, which imparts liquidity risk. The basic business of banking is to manage these two sets of cash flows, each having a different, stochastic structure. As the history of bank runs and failures indicates, managing these cashflows is inherently risky and banking is prone to instability.3

This tendency toward instability does not seem to have diminished in the 1990s, and may have increased. In modern finance, financial institutions’ off-balance-sheet business entails extensions of credit. For example, a simple swap transaction is a two-way credit instrument in which each counterparty promises to make a schedule of payments over the life of the contract. Each counterparty is both a creditor and debtor and, as in traditional banking, the modern financial institution has to manage the cash inflows (the creditor position) and outflows (the debtor position) associated with the derivatives contract. But there are important differences. First, the embedded credit risk is considerably more complicated and less predictable than the credit risk in a simple loan because the credit exposures associated with derivatives are time-varying and depend on the prices of underlying assets. Traditional bank lending is largely insulated from market risk because banks carry loans on the balance sheet at book value, meaning they may not recognize and need not respond to market shocks. Nevertheless, market developments can contribute to unrecognized losses that can accumulate over time. By contrast, OTC credit exposures are subject to volatile market risk and are, as a matter of course, marked to market every day. This creates highly variable profit-and-loss performance, but it imparts market discipline and also avoids undetected accumulations of losses. Day-to-day shifts in the constellation of asset prices can have a considerable impact on credit risk exposures—both the exposures borne by any particular financial institution and the distribution and concentration of such exposures throughout the international financial system.

Second, the dynamics of modern finance are considerably more complex than those of deposit markets. Deposit flows have a degree of regularity associated with the flow of underlying business. By contrast, flows associated with OTC derivatives and liquidity conditions in these markets, and in related markets, can be highly irregular and difficult to predict, even for the most technically advanced dealers with state-of-the-art risk management systems. Overall, the stochastic processes that govern the cash flows associated with OTC derivatives are inherently more difficult to understand, and seem to be more unstable during periods of extreme volatility in underlying asset prices.

Precision Finance, Desegmentation and Conglomeration, and Market Integration1

The main changes that have characterized the globalization of finance and risk can be summarized in the following points:

  • Greater use of modern precision finance to unbundle, price, trade, and manage complex financial risks.

  • Transformation of banking from concentration on lending (leverage and maturity transformation are traditional definitions of banks), to diversification into fee-and service-based businesses.

  • Transformation of balance-sheet activities into securitized loans and off-balance-sheet positions.

  • Rapid and continued growth in the importance of institutional investors, and the associated bank disintermediation; institutional investors manage more than $23 trillion.

  • Conglomeration of financial activities into large institutions providing traditional banking, investment banking, insurance, and other financial services.

  • Emergence of internationally active (global) financial institutions (banks, institutional investors, and conglomerates).

  • More highly integrated markets, with greater diversity in the quality, sophistication, and geographic-origins of borrowers and lenders.

  • Larger exposures to non-home markets.

The confluence of these changes has been associated with: greater mobility of capital; an accelerated expansion of cross-border financial activity; greater interdependencies between market participants, markets, and financial systems; greater market efficiency and liquidity in international markets; and faster speeds of adjustment of financial flows and asset prices.

1 See Annex V in International Monetary Fund (1998).

Thus, in addition to assessing and managing the risk of default and the expected loss given default, the modern financial institution has to assess the potential change in the value of the credit extended and form expectations about the future path of underlying asset prices. This, in turn, requires an under standing of the underlying asset markets and establishes a link between derivatives and underlying asset markets.

The Role of OTC Currency Options in the Dollar-Yen Market

OTC derivatives activities can exacerbate disturbances in underlying markets—even some of the largest markets, such as foreign exchange markets. This was, for example, the case in the dollar-yen market in March 1995 and October 1998; once the yen had appreciated beyond a certain level, the cancellation of OTC knockout options and the unwinding of associated hedging positions fueled the momentum toward further appreciation.1 During these periods of heightened exchange rate volatility, OTC derivatives activities also significantly influenced exchange-traded option markets, because standard exchange-traded options were used by derivatives dealers as hedging vehicles for OTC currency options.

In 1995, the yen appreciated vis-à-vis the dollar from ¥101 in early January to ¥80 in mid-April, strengthening by 7 percent in four trading sessions between March 2 and March 7. A combination of macroeconomic factors was widely cited as having contributed to the initial exchange rate move. The speed of the move also suggests that technical factors (such as the cancellation of knockout options) and short-term trading conditions (such as the unwinding of yen-carry trades, also involving OTC derivatives) reinforced the trend. In early 1995, relatively large volumes of down-and-out dollar put options were purchased by Japanese exporters to partially hedge the yen value of dollar receivables against a moderate yen appreciation.

In September-October 1998, the yen again appreciated sharply vis-à-vis the dollar from ¥135 to ¥120 per dollar. Of particular interest are the developments during October 6–9, 1998, when the yen strengthened by 15 percent in relation to the dollar. Talk of an additional fiscal stimulus package in Japan and a reassessment of the relative monetary policy stances in Japan and the United States may have sparked the initial rally in the yen and corresponding weakening in the dollar. The initial spate of dollar selling, in turn, was viewed as having created the sentiment that the dollar’s long-standing strengthening vis-à-vis the yen had run its course. But as in March 1995, in addition to reversals of yen-carry trades, knockout options were widely viewed as having provided additional momentum that boosted demand for yen and contributed to the dollar selling.

Knockout options (a type of OTC barrier option) differ from standard options in that they are canceled if the exchange rate reaches certain knockout levels, and therefore leave the investor unhedged against large exchange rate movements. Nonetheless, they are widely used since they are less expensive than standard options. In 1995 and 1998, knockout options, particularly down-and-out put options on the dollar, amplified exchange rate dynamics through two separate channels: (1) Japanese exporters who bought knockout options to protect against a moderate depreciation of the dollar sold dollars into a declining market when the knockout options were canceled to prevent further losses on their dollar receivables; and (2) dynamic hedging strategies employed by sellers of knockout options required the sudden sale of dollars after the knockout levels had been reached (see Box 3.3). Ironically, OTC knockout options that protect only against moderate exchange rate fluctuations can sometimes increase the likelihood of large exchange rate movements—the very event they do not protect against.

Although knockout options represented a relatively small share of total outstanding currency options (between 2 and 12 percent), they had a profound effect on the market for standard exchange-traded options. It is easy to see why: knockout options are sometimes hedged by a portfolio of standard options. Dealers who employed this hedging technique needed to buy a huge amount of standard options at the same time as other market participants were trying to contain losses from canceled down-and-out puts. As a consequence, prices of exchange-traded put options (implied volatilities) doubled in March 1995 and almost doubled in October 1998.

1 See International Monetary Fund (1996, and 1998b, Box 3.1) and Malz (1995).

Importance of OTC Derivatives in Modern Banking and Global Finance

The unpredictable, and at times turbulent, nature of OTC derivatives markets would merit little concern if OTC derivatives were an insignificant part of the world of global finance. They are not, and they are increasingly central to global finance. OTC derivatives markets are large, at mid-2000 comprising $94 trillion in notional principal, the reference amount for payments, and $2.6 trillion in (off-balance-sheet) credit exposures (see Section III). The markets comprise the major international financial institutions (Table 2.1), and together the instruments and markets interlink the array of global financial markets through a variety of channels.4

Table 2.1.

Top Twenty Derivatives Dealers in 2000 and Their Corresponding Ranks in 1999

article image
Source: Clow (2000). pp. 121–25.

Includes BT Alex Brown for 2000.

Ranking of Banque Paribas for 1999.

Chicago Mercantile Exchange (CME); London International Financial Futures and Options Exchange (LIFFE): European Derivatives Market (EUREX); Hong Kong Futures Exchange (HKFE); Tokyo Stock Exchange (TSE); and Tokyo International Financial Futures Exchange (TIFFE).

In the past two decades, the major internationally active financial institutions have significantly increased the share of their earnings from derivatives activities, including from trading fees and proprietary trading profits. These institutions manage portfolios of derivatives involving tens of thousand of positions, and daily aggregate global turnover now stands at roughly $1 trillion. The market can be seen as an informal network of bilateral counterparty relationships and dynamic, time-varying credit exposures whose size and distribution are intimately tied to important asset markets. Because each derivatives portfolio is composed of positions in a wide variety of markets, the network of credit exposures is inherently complex and difficult to manage. During periods in which financial market conditions stay within historical norms, credit exposures exhibit a predictable level of volatility, and risk management systems can, within a tolerable range of uncertainty, assess the riskiness of exposures. Risk management systems guide the rebalancing of the large OTC derivatives portfolios, which in normal periods can enhance the efficient allocation of risks among firms, but which can also be a source of trading and price variability—especially in times of financial stress—that feeds back into the stochastic nature of the cashflows.

LTCM and Turbulence in Global Financial Markets1

The turbulent dynamics in global capital markets in late 1998 had been preceded by a steady buildup of positions and prices in the mature equity and bond markets during the years and months preceding the Russian crisis in mid-August 1998 and the near collapse of the hedge fund LTCM in September. The bullish conditions in the major financial markets continued through the early summer of 1998, amid earlier warning signs that many advanced country equity markets, not just in the United States, were reaching record and perhaps unsustainable levels. As early as mid-1997, differences in the cost of borrowing between high-and low-risk borrowers began to narrow to the point where several advanced country central banks sounded warnings that credit spreads were reaching relatively low levels and that lending standards had been relaxed in some countries beyond a reasonable level. A complex network of derivatives counterparty exposures, encompassing a very high degree of leverage, had accumulated in the major markets through late summer 1998. The credit exposures and high degree of leverage both reflected the relatively low margin requirements on over-the-counter derivative transactions and the increasingly accepted practice of very low, or zero, “haircuts” on repo transactions.

Although the weakening of credit standards and complacency with overall risk management had benefited a large number of market participants, including a variety of highly leveraged institutions (HLIs), LTCM’s reputation for having the best technicians as well as its high profitability during its relatively brief history earned it a particularly highly valued counterparty status. Many of the major internationally active financial institutions actively courted LTCM, seeking to be LTCM’s creditor, trader, and counterparty. By August 1998, and with less than $5 billion of equity capital, LTCM had assembled a trading book that involved nearly 60,000 trades, including on-balance-sheet positions totaling $125 billion and off-balance-sheet positions that included nearly $1 trillion of notional OTC derivative positions and more than $500 billion of notional exchange-traded derivatives positions. These very large and highly leveraged trading positions spanned most of the major fixed income, securities, and foreign exchange markets, and involved as counterparties many of the financial institutions at the core of global financial markets.

Sentiment weakened generally throughout the summer of 1998 and deteriorated sharply in August when the devaluation and unilateral debt restructuring by Russia sparked a period of turmoil in mature markets that was virtually without precedent in the absence of a major inflationary or economic shock. The crisis in Russia sparked a broad-based reassessment and repricing of risk and large-scale deleveraging and portfolio rebalancing that cut across a range of global financial markets. In September and early October, indications of heightened concern about liquidity and counterparty risk emerged in some of the world’s deepest financial markets.

A key development was the news of difficulties in, and ultimately the near-failure of, LTCM, an important market-maker and provider of liquidity in securities markets, LTCM’s size and high leverage made it particularly exposed to the adverse shift in market sentiment following the Russian event. On July 31, 1998, LTCM had $4.1 billion in capital, down from just under $5 billion at the start of the year. During August atone, LTCM lost an additional $1.8 billion, and LTCM approached investors for an injection of capital.

In early September 1998, the possible default and/or bankruptcy of LTCM was a major concern in financial markets. Market reverberations intensified as major market participants scrambled to shed risk with LTCM and other counterparties, including in the commercial paper market, and to increase the liquidity of their positions. LTCM’s previous “preferred creditor” status evaporated, its credit lines were withdrawn, and margin calls on the fund accelerated. The major concerns were the consequences—for asset prices and for the health of LTCM’s main counterparties—of having to unwind LTCM’s very large positions as well as how much longer LTCM would be able to meet mounting daily margin calls. As a result, LTCM’s main counterparties demanded additional collateral. On September 21, Bear Stearns—LTCM’s prime brokerage firm—required LTCM to put up additional collateral to cover potential settlement exposures. Default by as early as September 23 was perceived as a very real possibility for LTCM in the absence of an injection of capital.

In response to these developments and the rapid deleveraging, market volatility increased sharply, and there were some significant departures from normal pricing relationships among different asset classes. In the U.S. treasury market, for example, the spread between the yields of “on-the-run” and “off-the-run” treasuries widened from less than 10 basis points to about 15 basis points in the wake of the Russian debt restructuring, and to a peak of over 35 basis points in mid-October, suggesting that investors were placing an unusually large premium on the liquidity of the “on-the-run” issue. Spreads between yields in the eurodollar market and on U.S. treasury bills for similar maturities also widened to historically high levels, as did spreads between commercial paper and treasury bills and those between the fixed leg of fixed-for-floating interest rate swaps and government bond yields, pointing to heightened concerns about counterparty risk. Interest rate swap spreads widened in currencies including the U.S. dollar, deutsche mark, and pound sterling. In the U.K. money markets, the spread of sterling interbank rates over general collateral repo rates rose sharply during the fourth quarter, partly owing to concerns about liquidity and counterparty risk (and also reflecting a desire for end-of-year liquidity).

As securities prices fell, market participants with leveraged securities positions sold those and other securities to meet margin calls, adding to the decline in prices. The decline in prices and rise in market volatility also led arbitrageurs and market-makers in the securities markets to cut positions and inventories and withdraw from market-making, reducing liquidity in securities markets and exacerbating the decline in prices. In this environment, considerable uncertainty about how much an unwinding of positions by LTCM and similar institutions might contribute to selling pressure fed concerns that the cycle of price declines and deleveraging might accelerate.

In response to these developments, central banks in major advanced economies cut official interest rates. In the United States, an initial cut on September 29 failed to significantly calm markets; spreads continued to widen, equity markets fell further, and volatility continued to increase. Against this background, the Federal Reserve followed up on October 15 with a cut in both the federal funds target and the discount rate, a key policy action that stemmed and ultimately helped reverse the deteriorating trend in market sentiment. The easing—coming so soon after the first rate cut and outside a regular FOMC meeting (the first such move since April 1994)—sent a clear signal that the U.S. monetary authorities were prepared to move aggressively if needed to ensure the normal functioning of financial markets.

Calm began to return to money and credit markets in mid-October. Money market spreads declined quickly to precrisis levels, while credit spreads declined more slowly and remained somewhat above precrisis levels, probably reflecting the deleveraging. The Federal Reserve cut both the federal funds target and the discount rate at the FOMC meeting on November 17, noting that although financial market conditions had settled down materially since mid-October, unusual strains remained. Short-term spreads subsequently declined. The calming effect of the rate cuts suggested that the turbulence stemmed primarily from a sudden and sharp increase in pressures on (broadly defined) liquidity, including securities market liquidity, triggered by a reassessment of risk.

1 This box draws on the analysis in International Monetary Fund (1998b, 1999).

Expansions and contractions in the level of OTC derivatives activities are a normal part of modern finance and typically occur in a nondisruptive manner, if not smoothly, even when there is isolated turbulence in one underlying market. The potential for excessively rapid contractions and instability seems to emerge when credit exposures in OTC activities rise to levels that create hypersensitivity to sudden unanticipated changes in market conditions (such as interest rate spreads) and new information. The creditor and debtor relationships implicit in OTC derivatives transactions between the internationally active financial institutions can create situations in which the possibility of isolated defaults can threaten the access to liquidity of key market participants—similar to a traditional bank run. This can significantly alter perceptions of market conditions, and particularly perceptions of the riskiness and potential size of OTC derivatives credit exposures. The rapid unwinding of positions, as all counterparties run for liquidity, is characterized by creditors demanding payment, selling collateral, and putting on hedges, while debtors draw down capital and liquidate other assets. Until OTC derivatives exposures contract to a sustainable level, markets can remain distressed and give rise to systemic problems. This is what happened in 1998: after it became known that LTCM might default, some dealers were concerned that their dealer counterparties were heavily exposed to LTCM. The induced changes in market conditions quickly created a run for liquidity.

Greater asset price volatility related to the rebalancing of portfolios may be a reasonable price to pay for the efficiency gains from global finance. However, in the 1990s, OTC derivatives activities have sometimes exhibited an unusual volatility and have added to the historical experience of what volatility can mean. For example, in the 1990s, there were repeated periods of volatility and stress in different asset markets (ERM crises; bond market turbulence in 1994 and 1996; Mexican, Asian, and Russian crises; LTCM; Brazil) as market participants searched for higher rates of return in the world’s major bond, equity, foreign exchange, and derivatives markets. Some of these episodes suggest that the structure of market dynamics has been adversely affected by financial innovations and become more unpredictable, if not unstable.

Examples of extreme market volatility include movements in the yen-dollar rate in both 1995 and 1998. In both cases the yen-dollar exchange rate exhibited what might be characterized as extreme price dynamics—beyond what changes in fundamentals would suggest was appropriate—in what was, and is, one of the deepest and most liquid markets. The extreme nature of the price dynamics resulted in pan from hedging positions involving the use of OTC derivatives contracts called knockout options (see Box 2.2: The Role of OTC Currency Options in the Dollar-Yen Market, page 5). These OTC options are designed to insure against relatively small changes in an underlying asset price. Yet once a certain threshold level of the yen-dollar rate was reached, (he bunching of these OTC options drove the yen-dollar rate to extraordinary levels in a very short period of time—an event that the OTC options were not designed to insure against.

Such episodes of rapid and severe dynamics can also pose risks to systemic stability. In particular, the turbulence surrounding the near-collapse of LTCM in the autumn of 1998 posed the risk of systemic consequences for the international financial system, and seemed to have created consequences for real economic activity (see Box 2.3: LTCM and Turbulence in Global Financial Markets, page 6). This risk was real enough that major central banks reduced interest rates to restore risk taking to a level supportive of more normal levels of financial intermediation and continued economic growth. LTCM’s trading books were so complicated and its positions so large that the world’s lop derivatives traders and risk managers from three major derivatives houses could not determine how to unwind LTCM’s derivatives books rapidly in an orderly fashion without retaining LTCM staff to assist in liquidating the large and complex portfolio of positions.

Both private market participants and those responsible for banking supervision and official market surveillance are learning to adapt to the fast pace of innovation and structural change. This challenging learning process has been made more difficult because OTC derivatives activities may have changed the nature of systemic risk in ways that are not yet fully understood.5 The heavy reliance on OTC derivatives appears to have created the possibility of systemic financial events that fall outside of the more formal clearinghouse structures and official real-time gross-payment settlement systems that are designed to contain and prevent such problems. There is the concern that heavy reliance on new and even more innovative financial techniques, and the possibility that they may create volatile and extreme dynamics, could yet produce even greater turbulence with consequences for real economic activity—perhaps with consequences reaching the proportions of real economic losses typically associated with financial panics and banking crises.

In sum, the internationally active financial institutions have increasingly nurtured the ability to profit from OTC derivatives activities and financial market participants benefit significantly from them. As a result, OTC derivatives activities play a central and predominantly a beneficial role in modern finance. Nevertheless, the important role of OTC derivatives in modern finance, and in particular in recent periods of turbulence, raises the concern that the instabilities associated with modern finance and OTC derivatives markets could give rise to systemic problems that potentially could affect the international financial system.

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Cover Modern Banking and OTC Derivatives Markets
Modern Banking and OTC Derivatives Markets
The Transformation of Global Finance and its Implications for Systemic Risk
ISBN:
9781557759993
ISSN:
0251-6365
Publication Date:
09 Jan 2001
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557759993.084
Pages:
77

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