V Key Features of OTC Derivatives Activities
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Mr. Charles Frederick Kramer
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Mr. R. S Craig
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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.

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.

First, OTC derivative contracts are credit instruments. Even a simple plain vanilla interest-rate swap is a two-way credit instrument. For example, when two counterparts enter into an interest-rate swap, they trade cash flows associated with fixed and variable interest rate payments based on a notional value of the fixed-income instrument. While the principal (or notional value) of the contract is not at risk, the cash flows are, because they constitute a debt of one counterparty to the other. In addition, the stream of net cash payments varies with changes in the difference between the fixed and variable rates, giving rise to a potential future credit exposure (PFE).95 As a result, the debtor/ creditor relationship can vary over the life of the contract. One counterpart can be the net creditor (receiver of the cash flow) at the initiation of the contract, and because of changes in interest rates later become the net debtor (payer of the cash flow). In contrast, futures contracts do not embody much credit risk because the exchange or clearinghouse generally stands between counterparties and acts as a central counterparty for exchange-executed transactions by managing the credit risk through rules governing initial and variation margin, and settling defaults through loss-sharing arrangements.96, 97 With OTC derivatives, the counterparties manage the bilateral creditor/debtor relationship, and incur the losses of default.

Second, OTC derivatives transform financial risks. They help financial institutions tailor, hedge, and manage risks with more precision and flexibility than can be achieved using other financial instruments, including exchange-traded derivatives. The capacity to unbundle, repackage, and transform risk provides increased opportunities for diversification and hedging of risk. It also makes it possible to separately price the different types of risk embodied in a financial instrument. This, in turn, enables institutions to select those types of risks they want to hold and hedge or sell those that they do not. In this way, OTC derivatives markets contribute to a more complete set of markets for trading and managing risk. Derivatives thus allow agents to tailor more precisely the risk characteristics of financial instruments to their risk preferences and tolerances. By contributing to more complete financial markets, derivatives can also improve market liquidity and increase the capacity of the financial system to hear risk and intermediate capital.

To see this, consider the example of a company that issued a medium-term variable-rate bond last year expecting interest rates to decline, but that now expects interest rates to rise. The company can issue a new bond at a fixed interest rate and pay back the variable rate bond, but this may be too costly given prepayment penalties, underwriting ices, and other costs. Alternatively, the company can find a counterpart who expects interest rates to decline and is willing to pay (or receive) the difference between the variable and fixed rates. This is a swap, the most widely used OTC derivatives contract. In choosing the swap as its financing option, the company alters its risks and obligations in several key ways; while the company remains a (gross) debtor, it transforms the nature of its market risk; it now has to manage two cash flows (a variable-rate payment, and a fixed-rate receipt); and it becomes a (gross) creditor to the fixed-rate payer and has to manage the associated counterparty risk. The company may also decide to mitigate part of the counterparty risk by taking some collateral against the cash flow it is promised to receive, which adds operational complexity and some legal uncertainty. For example, if the paying counterpart goes bankrupt, the company might have to follow legally cumbersome closeout procedures for liquidating the position. This example of a plain vanilla swap illustrates how a simple OTC derivative can transform market risk into a combination of market, credit, and operational risks. In practice, financial intermediaries hold portfolios of OTC derivatives involving different combinations of these risks. To manage them effectively and take full advantage of their risk-transforming nature, sophisticated risk management and control systems are essential.

Third, the institutions that intermediate the bulk of transactions in OTC derivative markets are the large, internationally active financial institutions (see Table 2.1). These institutions also intermediate a large share of international capital flows and handle the lion’s share of global lending, underwriting, mergers and acquisitions, and trading businesses. Their size, sophistication, diversification, and global reach give them a significant competitive advantage over smaller, more specialized institutions in the derivatives business. They have expanded and diversified their businesses in order to capture economies of scale and scope. These economies arise from the huge investments required to run a profitable global OTC derivatives business—in information and computer technologies, and in financial infrastructure—and from complementarities between OTC derivatives and other lines of business (for example, between fixed-income derivatives dealing and bond dealing and underwriting). As the head of a global OTC derivatives trading operation has stated, “the OTC derivatives business is like a team sport; you can only be profitable if all aspects of the global business—sales, trading, back-office, information systems, risk management and control—are working effectively together.” These global institutions are typically strongly capitalized, usually well-managed, and normally manage risk skillfully. They all have high credit ratings, which is critical for being viewed as a creditworthy counterparty in OTC derivatives transactions.

Fourth, OTC derivatives markets are essentially interbank and interdealer markets (similar to the major domestic money and foreign-exchange markets). The major institutions actively trade among themselves and make up a large share of the daily turnover in these markets. In 1998, for example, contracts between the major participants accounted for roughly one-half of notional principal in interest-rate derivatives (over half of the turnover) and one-third of notional principal in foreign-exchange derivatives (and about two-thirds of the turnover). This turnover results from two types of interbank and interdealer activity: the intermediation of derivatives transactions on behalf of clients—insurance companies, pension funds, asset management companies, hedge funds, and nonfinancial companies: and efforts by intermediaries to manage exposures and risks from these derivatives transactions with clients. For example, a large multinational corporation might ask a bank to arrange a swap out of a five-year variable-rate bond it issued in one currency a year ago into a fixed-rate bond in another currency for the remaining four years. The bank may enter the swap with the company even though it might not want the full exposure (that could entail many risks including interest-rate, foreign-exchange, and counterparty risk). It does so, in part, because it might expect a profit from one exposure (interest rate), and because it might need to build inventory in another type of instrument (for example, foreign exchange) in which it is a market maker. The bank therefore could unbundle the various components of exposures and risks, keep some of them for its own inventory and portfolio of risks, and sell off the remaining, often sizable, exposures to other counterparties that typically are the other internationally active financial institutions. In this way. a single transaction with an end-user can result in a huge volume of interbank and interdealer hedging and rebalancing activity in many market segments.98

Fifth, OTC derivatives markets are becoming concentrated among fewer but larger intermediaries. The level of concentration has increased over time, driven in large part by the economies of scale and scope required to be profitable in these highly efficient markets. This includes both a higher concentration of trading and counterparty exposures, in part because there are fewer counterparts with the capacity to hedge and rebalance OTC derivatives portfolios actively and profitably. Two recent examples of mergers that have increased this concentration are the merger between Deutsche Bank and Bankers Trust, both having very large and active global derivatives businesses, and the creation of Citigroup, which combines two active participants in OTC derivatives markets, Citicorp (a large commercial bank) and Salomon Smith Barney (a major securities house) with Travelers (a major insurance company). Moreover, smaller participants have been relatively inactive as intermediaries since the September 1998 market turbulence, and some former major participants (for example, Japanese banks) have scaled back their international OTC derivatives activities. Concentration may increase further if the pace of restructuring and consolidation picks up, particularly with the elimination of Glass-Steagall barriers between commercial and investment banks in the United States; the efforts to create “national champions” in Europe; and the creation of mega-banks in Japan.

Sixth, OTC derivatives markets are global and have become central to the efficient functioning of the international financial system. They closely link institutions, markets, and financial centers. They have become a major driving force behind the integration of national financial markets and the globalization of finance. The most obvious linkages arise from the contracts themselves. Currency swaps are used to transform currency risks and mobilize liquidity internationally across the major financial centers. Linkages also occur through the internationally active financial institutions that make up these markets, OTC derivatives markets also link the major dealing institutions, first through the array of market risks, and importantly, through a complex lattice of multiple, bilateral counterparty relationships between the major intermediaries. In addition, hedging, pricing, and arbitrage activities link OTC derivatives markets to the major cash and exchange-traded derivatives markets. For example, hedging and arbitrage activities link the market for interest-rate swaps and the markets for bonds, interest-rate and bond futures, and interest-rate options. The inter-linkages and the opportunities for arbitrage that they provide add to the efficiency and complexity of the international financial system.

Seventh, OTC derivatives can enhance or reduce market liquidity in different situations. Market liquidity allows participants to trade at prices that are not systematically affected by the size of the transaction, or technical market conditions. This makes it more likely that prices reflect fundamental demand and supply factors and increases economic and financial efficiency. OTC derivatives can support and enhance market liquidity. For example, because of their low cost and flexibility, OTC derivatives contracts are efficient vehicles for facilitating position taking and hedging. In effect, they are financing vehicles that augment other, more traditional mechanisms (like lines of credit) for maintaining and enhancing market liquidity. OTC derivatives activities can also be supportive of liquidity in related markets. Indeed, hedging of dollar interest-rate swaps has been credited with significantly improving market liquidity in the Eurodollar futures market. In other situations, OTC derivatives can absorb or reduce market liquidity. Because OTC derivatives involve extensions of credit, their financing—and refinancing when market conditions change—relies heavily on access to various sources of short-term credit, including interbank money markets and bank lines of credit. Situations can arise in which, for example, a rise in the cost of funding positions in a particular OTC derivatives market segment might make it too costly for a group of dealers trading in that market to continue to intermediate or carry particular OTC derivatives positions, and they might decide to reduce (temporarily) their level of activity. This would reduce turnover and liquidity in that segment, which in turn can reduce market liquidity overall. Given the relative size of OTC derivatives markets, a sharp reduction in activity can have a significant impact on market liquidity in related derivatives and spot markets.

Eighth, OTC derivatives contracts naturally embody leverage (see Box 5.1: Off-Balance-Sheet Leverage). For an individual investor, leverage enhances the potential return on an asset relative to capital. This can be achieved relatively easily and cheaply with OTC derivatives, in part because they are flexible credit instruments. For example, by buying an interest-rate swap—paying flouting interest and receiving fixed interest—an investor can essentially buy a fixed-rate bond and finance it through a floating-rate loan, and thereby take a position on long-term interest rates for only a fraction of the amount that would be required to buy a long-term bond outright. The swap economizes on the use of up-front capital in taking the risk—freeing capital for other transactions—and enhances the return (or loss) relative to the capital invested. If interest rates fall, the swap (like a long-term bond) appreciates in value, and the investor receives a relatively high return on invested capital; if interest rates rise, the swap depreciates in value, and the investor will probably be required to put up more capital or borrow again to make the additional payment, and thereby will experience a loss relative to invested capital. Thus, compared with an outright (unleveraged) investment in the underlying asset, the leveraged investment in an OTC derivatives contract has greater upside potential, but it also embodies higher risk relative to the capital invested, and it can put at risk the investor’s overall capital if it is not well managed. Taking this example to the level of the market, the more active and liquid is the swap market, the greater is the likelihood that long-term bonds will also trade in a liquid market. This is because swaps allow risks associated with long-term bonds to be precisely hedged or leveraged, and this makes bonds attractive to a larger set of investors. However, the implied leverage in the swap market can magnify the effect of changes in the bond market.

Off-Balance-Sheet Leverage

Leverage is the magnification of the rate of return (positive or negative) on a position or investment beyond the rate obtained by a direct investment of own funds in the cash market. Leverage is of concern because by definition it creates and enhances the risk of default by market participants; and it increases the potential for rapid deleveraging—the unwinding of leveraged positions—which can cause major disruptions in financial markets by exaggerating market movements.1

For private and systemic risk management, and market surveillance, it would be useful to have broad measures of the extent of leveraged positions in capital markets. This knowledge would allow market participants to assess the potential for rapid price movements resulting from exogenous adverse market shocks that may cause investors to deleverage in an attempt to mitigate their losses. Anticipation of possible turbulent deleveraging might limit the buildup of unsustainable leverage. Hence, a publicly available measure for overall leverage by institutions and in markets could enhance self-stabilizing forces without necessitating disclosure of proprietary position data to the public. Since leverage in modern financial markets can easily be assumed by using derivative contracts, it is useful to have a measure that not only captures on-balance-sheet leverage but also the leverage implicit in off-balance-sheet transactions. Despite the importance of leverage, empirical measures of leverage are difficult to implement.

Leverage is traditionally measured by the ratio of a firm’s total assets relative to its equity. Calculating this ratio is straight forward if the firm only relies on balance-sheet transactions, such as bank loans. However, if the firm uses off-balance-sheet transactions, such as derivative instruments, the measurement of leverage is more complicated. This box first explains how the leverage that is implied by the most common derivative instruments could be measured. More complicated derivatives, such as swaps and structured notes, can generally be decomposed into spot market, forward, and option positions and will therefore not be considered separately. The box also presents methods for aggregating leverage within an institution and within markets.2

Leverage Implicit in Plain Vanilla Derivative Instruments

To assess leverage resulting from a derivative contract, the contract can be decomposed into its cash market equivalent components. The basic derivative instruments—forwards and options—can be replicated by holding (and, in the case of options, constantly adjusting) positions in the spot market of the underlying security, and by borrowing or lending in the money market. This replication of the contract maps the individual components into own-funds equivalents (equity) and borrowed-funds equivalents (debt), which can be used to measure the leverage contained in long and short forward positions and option contracts.

Consider, as an example, a long forward contract on a security that, for simplicity, provides no (interest or dividend) income. Purchasing a security forward is equivalent to borrowing cash at the risk-free interest rate, supplementing the borrowed funds with own funds in the amount that would otherwise be spent on the forward contract, and investing the total amount in the underlying asset. In the replicating portfolio, own funds are equivalent to the market value of the contract;3 the sum of own and borrowed funds is equivalent to the contract’s current notional value.4 Hence, the leverage ratio implicit in a forward contract is defined as the current notional value relative to the contract’s market value. As a short forward position is tantamount to a short position in the underlying asset, its leverage ratio—defined in the same way as that of a long forward ratio—is negative. To compare leverage ratios for short positions and long positions, it is therefore necessary to take the absolute value of leverage ratios for short positions. Leverage ratios for long and short option positions can be calculated in a similar fashion (see table).

As the price of the underlying asset changes, the value of the forward contract—and thus the value of equity—will change, which implies a continually changing leverage ratio. This is similar to on-balance-sheet leverage: as the value of the underlying security increases (decreases), the investor’s equity rises at a faster rate than the value of the assets, thereby reducing the leverage ratio; and vice versa. The leverage ratio could ultimately reach infinity when losses equal the equity in the position.5 However, for exchange-traded derivatives the ratio is bounded as a result of margin requirements. Futures margin requirements range between 2 percent, implying a maximum leverage ratio of 50, and 8 percent, implying a maximum ratio of 12.5. Although leverage in forward contracts is typically not bounded by margin requirements, it may be limited by overall credit and trading limits that institutions have with each other.

Leverage Ratios in Basic Derivative Instruments

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The “delta” of an option—also called the “hedge ratio”—is defined as the rate of change of the option price with respect to the price of the underlying asset.

The delta of a put option, Δpt is related to the delta of an equivalent call option (Δptct-I).

Aggregate Leverage of a Financial Institution

The mapped asset components can be aggregated for an institution and expressed relative to its on-balance-sheet equity. There are at least two ways of aggregating assets to arrive at an overall measure of leverage for a financial institution: the “gross leverage ratio” and the “net leverage ratio.” Both ratios add the spot market asset equivalent components in some form to on-balance-sheet assets before dividing by on-balance-sheet equity.6 To the extent that the institution’s overall equity is positive, the leverage ratio will be less than infinity, even though some of its positions may have infinite leverage.

The “gross leverage ratio” adds the absolute amount of short (negative) asset equivalents to that of long (positive) positions. Hence, this ratio, in general, overstates the total market exposure as short positions may offset long positions to some extent. Subtracting short asset positions from long asset positions yields the “net leverage ratio,” which is smaller than the gross leverage ratio. Both ratios measure the relationship between an investor’s exposure and that investor’s equity. While the net leverage ratio may more accurately reflect the market risk of a leveraged investor, it does not take into account credit and liquidity risk inherent in the individual contracts. By contrast, the gross leverage ratio incorporates all those risks.

As a third measure of leverage, the U.S. President’s Working Group on Financial Markets proposed the value at risk of an entity’s portfolio relative to its equity. This is not, however, a measure of leverage per se. Rather, it is a measure of risk and addresses whether an institution’s equity is sufficient to cover potential losses due to market risk. Hence, it could be called the “risk coverage ratio.” Unlike the leverage ratio, this ratio does not capture the extent to which the institution has pooled economic resources from outside debt investors and therefore its systemic importance. To judge the “riskiness” of an institution it would be useful to know all three ratios.7 Regulators are currently considering whether disclosure of these ratios ought to be required.

It is impossible to precisely measure leverage for institutions active in derivative markets without full knowledge of their positions, including hedges. However, data filed by commercial banks and trust companies in the United States with the Office of the Comptroller of the Currency allow an approximation. As gross market values of derivative positions (not subject to netting) are itemized as assets and liabilities on the balance sheet, changes in the value of these positions directly affect the firm’s equity. Hence, the ratio of current notional values outstanding to the equity of the institution indicates the extent of off-balance-sheet gross leverage. The sum of this ratio and the conventional balance sheet leverage ratio can serve as an approximation to the overall gross leverage ratio. The net leverage ratio cannot be calculated without further information about the nature of the positions.

Gross off-balance-sheet leverage of the top 25 U.S. banks, which in June 2000 held approximately 99 percent of the total notional amount of derivatives in the domestic banking system and 41 percent of derivatives outstanding worldwide, exceeded the leverage of the remaining domestic commercial banks by a wide margin.8 For the latter group the ratio ranged around 0.1, indicating virtually no derivatives activity.9 In the aftermath of the 1996 bond market turbulence and the associated deleveraging, leverage among the top 25 banks increased gradually from 70 in 1996 until the second quarter of 1998. It surged by 18 percent to 91 in the third quarter of 1998.10 The increase was largely due to an upsurge in derivatives exposures rather than a decrease in capital (see the figure). In contrast, traditional balance sheet leverage ranged between 6 and 7 during the same period. While the gross leverage ratio only provides an upper bound to net leverage, the relative movements confirm the concentration of off-balance-sheet leverage among a few banks and a significant increase of leverage during the third quarter of 1998. In the second half of 1999, the gross leverage ratio declined to around the levels that prevailed at mid–1998.

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United States: Top 25 Commercial Banks—Notional Amount of Derivatives, Equity Capital, and the Gross Off-Balance-Sheet Leverage Ratio, Fourth Quarter 1995–Second Quarter 2000

Source: Office of the Comptroller of the Currency.1 Tier I plus tier 2 capital.2 The gross off-balance-sheet leverage ratio is defined as the ratio of notional amount of derivatives outstanding divided by equity capital (tier 1 plus tier 2 capital).

Leverage in Markets

To determine the potential for financial market turbulence stemming from deleveraging it is useful to estimate the extent of leveraged positions in a particular market. In practice, it is not possible to gather such data without individual position data, particularly for off-balance-sheet transactions. However, the BIS survey of derivatives market activity allows approximations of the extent of leverage in certain derivatives markets on a global basis. The survey reports total gross notional amounts and total gross market values outstanding in various segments of the foreign exchange derivative and interest rate derivative markets at semiannual intervals. Notional amounts are aggregated in a similar fashion as suggested for the gross leverage ratio. Based on the definitions of leverage introduced above, the notional amounts outstanding divided by the gross market value approximates the gross leverage ratio.11

The data indicate that the overall approximate gross leverage ratio increased from 22 in 1995 to 36 in 2000 (see table). Interest rate derivative contracts had higher leverage ratios than foreign exchange derivative contracts, reflecting the fact that the latter—unlike the former—typically involve an exchange of principal. In addition, interest rates tend to be less volatile than exchange rates, so that market values of interest rate contracts (for a given notional amount) tend to be smaller than those of foreign exchange contracts. The latter also represent exposure to both currency and interest rate risks, which also contributes to a higher market value relative to the notional amount. The reported high degree of leverage in option contracts overstates actual leverage because of the implicit assumption of delta being unity.

Global Positions and Approximate Gross Leverage Ratios in Over-the-Counter Derivatives Markets by Type of Risk Instruments1

(Billions of U.S. dollars)

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Source: Bank for International Settlements.

All figures are adjusted for double-counting. Notional amounts outstanding have been adjusted by halving positions vis-à-vis other reporting dealers. Gross market values have been calculated as die sum of the total gross positive market value of contracts and the absolute value of gross negative market value of contracts with non-reporting counterparties.

Single-currency contracts only.

Adjustments for double-counting are estimated.

1 See International Monetary Fund (1998b), Box 3.3, and Breuer (2000). 2 Leverage has the capacity to increase risk. For a given equity base, leverage allows the borrower to build up a larger investment position and thus higher exposure to market risk. Since leverage increases the potential loss triggered by a given adverse price movement, leveraged investors are likely to adjust their positions sooner than pure equity investors. The simultaneous unwinding of large leveraged positions may, in turn, trigger further price movements and therefore increase risk. 3 The market value of a derivatives contract, in turn, might be financed by on-balance-sheet debt and on-balance-sheet equity. 4 The current notional value of a derivative contract is defined as the product of the number of underlying shares and their current market price. By contrast, the notional amount refers to the product of the number of underlying shares and the delivery (exercise) price specified in the contract. 5 Note that the leverage ratio in this box is defined to remain at infinity when losses exceed equity, even though the mathematical ratio would change signs. 6 Alternatively, the off-balance-sheet gross and net leverage ratios could be calculated by dividing the sum of asset equivalent components by the sum of equity equivalent components. Positions that have an infinite leverage ratio will contribute only to the numerator and not to the denominator. 7 Two important shortcomings are that these ratios, by their nature, need to be reported by the financial institutions themselves and that the VaR data are predicated on very specific assumptions. 8 Risk-based capital, the sum of Tier 1 and Tier 2 capital, was derived from data from the Office of the Comptroller of the Currency. 9 The reported figures overstate the gross leverage ratio because the “delta’” of option contracts is assumed to be 1 (owing to lack of data) and because the reported notional amounts are valued at exercise (delivery) prices, and not at current market prices. 10 One globally active bank reached a ratio as high as 579. 11 See footnote 9.

Ninth, OTC derivatives activities are relatively opaque. In traditional banking, when a bank issues a loan the risks are transparent even if they are not easily quantified and managed. With OTC derivatives transactions, it can be difficult to adequately gauge, assess and understand the distribution and balance of counterparty and other risks, including who owns which risks. Part of this lack of transparency originates in the ability of derivatives to unbundle and repackage separate components of risk. Opacity also reflects the organization of the market. In general, interbank and interdealer markets lack transparency except for actively engaged market participants. Major OTC derivatives intermediaries receive information about the distribution of risks and exposures by observing order flows, but they closely guard this information. In addition, transparency is much more limited in OTC deals than in exchange-traded transactions, in part because OTC derivatives deals are bilateral individual transactions.

Tenth, OTC derivatives markets are systemically important. Their systemic importance arises from two key characteristics of OTC markets and the intermediaries active in them. First, given the concentrated nature of OTC markets, the major players are a large enough share of the market to cause a market disruption if they were to encounter liquidity or solvency problems (especially those not part of the safely net). Second, in the event a global (and necessarily large) financial institution encountered a solvency problem, while the institution might not be too big or complex to close or liquidate, it might be too big to close and liquidate quickly without potentially causing a market disruption. This reflects the fact that global institutions have large balance sheets and similarly large off-balance-sheet positions. They are active in, and in the aggregate, largely comprise a wide variety of cash securities markets, interbank lending markets, and other international financial markets, and may span several legal and regulatory jurisdictions. They play a critical role in intermediating savings and international capital flows, and in supporting economic activity in an increasingly interconnected global economic and financial system. As these institutions are well aware of the public’s interest in these considerations, authorities consider it critical to strike a balance between establishing mechanisms to ensure soundness and limiting the moral hazard that such measures might engender. In this connection, and owing to the complex nature of these markets and institutions, authorities rely on market discipline.

These ten features highlight characteristics of OTC derivatives markets that distinguish them from other markets in four key areas; risks, structure, their financing role, and financial stability. Concerning risks, OTC derivatives have a unique capacity to transform and tailor risk but this gives rise to credit and other exposures that must be managed. More generally, the greater complexity of risks that results from their use requires sophisticated and effective risk management systems if the benefits of OTC derivatives markets are to be fully realized. What distinguishes the structure of OTC derivatives markets is that they depend on a relatively small number of large, globally active institutions to intermediate transactions and provide liquidity. Moreover, they are becoming more concentrated over time due to rising economies of scale and scope driven largely by technology. They play a central role linking financial institutions, markets, and centers thereby contributing to the globalization of the financial system. Regarding the financing role, OTC derivatives are efficient financial vehicles that contribute to market liquidity and can be used for leverage. Because they involve extensions of credit, the extent of their financing role depends on credit conditions and liquidity in money markets and bank financing. Important from a financial stability perspective, OTC derivatives markets are distinguished by their lack of transparency about who owns what risks. Finally, the large size of the active institutions and the concentration and complexity of the exposures to one another makes OTC derivatives markets systemically important. All of these key features bear importantly on the related financial stability issues discussed in the next section.

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The Transformation of Global Finance and its Implications for Systemic Risk
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