III The Growing Involvement of Banks in Derivative Finance—A Challenge for Financial Policy

International Monetary Fund
Published Date:
January 1993
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The markets for over-the-counter and exchange-traded derivative instruments have exhibited explosive growth in the late 1980s and early 1990s.52 In their continuing search for profitable new activities, the banking sectors in the major industrial countries have become extensively involved in these markets both by acting as dealers in the OTC market and as users of exchange-traded instruments. Indeed, the most notable development in the major financial markets during the past five years has been the growth in volume and in diversity of OTC financial derivative instruments. Exchange-traded derivative contracts have likewise grown at a dizzying pace, stimulated in large part by the OTC business of the banking sector. The notional value of outstanding exchange-traded and OTC contracts has grown from $1.6 trillion in 1987 to $8 trillion in 1991, or from about 35 percent to 140 percent of U.S. GDP (Table 6 and Chart 18).

Chart 18.Notional Principal Amounts Outstanding for Exchange-Traded and Over-the-Counter (OTC) Derivative Instruments1

(In billions of U.S. dollars equivalent, end-year data)

Source: Bank for International Settlements (1992), p. 49.

11986 data are estimates.

2 Excludes options on individual shares and derivatives involving commodity contracts; consists of futures and options (calls and puts) on currency, interest rate, and stock market index.

3 Only data collected by International Swap Dealers Association (ISDA). Excludes information on contracts such as forward rate agreements, OTC currency options, forward foreign exchange positions, equity swaps, and warrants on equity; includes interest rate and currency swaps (adjusted for reporting of both currencies) and other derivative instruments (caps, collars, floors, and swaptions).

Table 6.Markets for Selected Derivative Financial Instruments: Notional Principal Amounts Outstanding(In billions of U.S. dollars, end-year data)
Percent Change
Exchange-traded instruments5837251,3001,7622,2843,51850354
Interest rate futures3704888951,2011,4542,15948449
Interest rate options11461222793876001,07263479
Currency futures1014121616188012
Currency options1396048505659515
Stock market index futures15182842707741310
Options on stock market indices132338668813250
Over-the-counter (OTC) instruments2500 38661,3262,4233,4514,44979029
Interest rate swaps4400 36831,0101,5392,3123,06566633
Currency and cross-currency interest rate swaps4, 5100 318331643457880770740
Other derivative instruments3, 4, 64505615773
Sources: Bank for International Settlements (BIS) calculations; United States, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency (1993); Futures Industry Association (FIA); IMF staff estimates; International Swap Dealers Association (ISDA); and various futures and options exchanges worldwide.

Calls plus puts.

No statistics are available on forward rate agreements or OTC foreign exchange options. Only data collected by ISDA.


Contracts between ISDA members reported only once.

Adjusted for reporting of both currencies.

Caps, collars, floors, and swaptions.

Sources: Bank for International Settlements (BIS) calculations; United States, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency (1993); Futures Industry Association (FIA); IMF staff estimates; International Swap Dealers Association (ISDA); and various futures and options exchanges worldwide.

Calls plus puts.

No statistics are available on forward rate agreements or OTC foreign exchange options. Only data collected by ISDA.


Contracts between ISDA members reported only once.

Adjusted for reporting of both currencies.

Caps, collars, floors, and swaptions.

This development has fundamentally altered the structure of finance and the interaction of markets.53 By now, the advantages that derivative markets offer for hedging price risks and for increasing the liquidity of underlying markets are well appreciated. In particular, the new instruments and techniques permit the separation and unbundling of risk, the pricing of its separate components (credit risk, liquidity risk, market risk), and the redistribution of risks to those best able to manage them. But the exponential growth of the derivatives market has forced regulators and other financial authorities to wonder if prudential considerations are being given sufficient attention. The fact that banking difficulties have so far emerged generally as a result of the mismanagement of credit risk is not entirely reassuring, since OTC activities are a recent phenomenon. After all, harking back to the principles of sound banking alluded to earlier, experience suggests that rapid expansion of, and concentration in, a particular banking activity often signals both a weakening of internal controls and an underassessment of credit risk.

This section begins by describing the recent expansion of trading activity in both OTC and exchange-traded derivative instruments and then concentrates specifically on bank activities in derivatives markets. The risks involved in dealing in derivatives and how banks manage these risks is then discussed, followed by the systemic implications and regulatory response of the heavy bank involvement in these markets.

Markets for Derivative Instruments

Measured activity in derivative financial instruments points to continued strong growth in these markets. The outstanding notional principal value of OTC instruments (mostly interest rate and currency swaps) increased to $4,449 billion at end-1991, an increase of 413 percent from end-1987 (Table 6). In the first half of 1992, $1,474 billion in new swaps was written, a 44 percent increase over the second half of 1991. The notional principle of exchange-traded derivative instruments has also registered strong growth, climbing to $3.5 trillion at end-1991, up 385 percent from end-1987. Derivative instruments have grown by a much wider margin than other financial instruments. As a rough indication of this trend, the ratio of the outstanding notional value of interest rate and currency derivative contracts to the international assets of banks rose from about 31 percent at end-1987 to 106 percent at end-1991.54

OTC Derivatives Markets

The most actively used OTC instruments are interest rate swaps, the notional principal value of which totaled $3,065 billion at end-1991, up 349 percent from end-1987 (Table 7). Interbank swaps rose from 30 percent of total swaps outstanding at end-1987 to 44 percent at end-1991. This development reflects the evolving role of swaps.55 In its early years, the market was dependent on new bond issues and arbitrage activity in capital markets; recently, however, investors, particularly financial institutions, are using interest rate swaps to hedge shorter-term exposures. Thus the weighted-average maturity of new U.S. dollar interest rate swaps declined to about 2.4 years in the second half of 1991 from 4 years in the first half of 1987. Another important development is the fall in the share of the U.S. dollar sector in total interest rate swaps outstanding from 79 percent at end-1987 to 49 percent at end-1991. Nondollar business continued to expand in the first half of 1992. Contracts denominated in the Japanese yen, deutsche mark, pound sterling, and French franc account for the bulk of the outstanding nondollar interest rate swaps.

Table 7.Currency Composition of Notional Principal Value of Outstanding Interest Rate and Currency Swaps(In billions of U.S. dollars)
Interest rate swaps
All counterparties682.91,010.21,502.62,311.53,065.1
U.S. dollar541.5728.2993.71,272.71,506.0
Japanese yen40.578.5128.0231.9478.9
Deutsche mark31.656.584.6193.4263.4
Pound sterling29.752.3100.4242.1253.5
Interbank (ISDA member)206.6341.3547.1909.51,342.3
U.S. dollar161.6243.9371.1492.8675.0
Japanese yen19.543.061.1126.1264.9
Deutsche mark7.917.232.678.4111.2
Pound sterling10.417.640.0100.1106.3
End user476.2668.9955.51,402.01,722.8
U.S. dollar379.9484.3622.6779.9831.0
Japanese yen21.035.566.9105.8214.0
Deutsche mark23.739.352.0115.0152.2
Pound sterling19.334.760.4142.0147.3
Currency swaps1
All counterparties182.8319.6449.1577.5807.2
U.S. dollar81.3134.7177.1214.2292.1
Japanese yen29.965.5100.6122.4180.1
Deutsche mark10.717.026.936.247.6
Pound sterling5.38.916.724.537.4
Interbank (ISDA member)35.582.6115.1155.1224.9
U.S. dollar16.734.148.259.786.8
Japanese yen7.218.628.337.460.9
Deutsche mark1.
Pound sterling1.
End user147.3237.0334.1422.5582.3
U.S. dollar64.6100.7128.9154.5205.3
Japanese yen22.747.072.285.0119.2
Deutsche mark9.114.021.528.538.2
Pound sterling4.27.312.418.329.0
Sources: Bank for International Settlements, International Banking and Financial Market Developments, various issues; and International Swap Dealers Association (ISDA).

Adjusted for double-counting as each currency swap involves two currencies.

Sources: Bank for International Settlements, International Banking and Financial Market Developments, various issues; and International Swap Dealers Association (ISDA).

Adjusted for double-counting as each currency swap involves two currencies.

The market for currency swaps, including cross-currency interest rate swaps, has also grown rapidly. The notional value of these swaps totaled $807 billion at end-1991, an increase of 342 percent from end-1987 (Table 7). However, in the first half of 1992 growth tapered off, with new currency swaps totaling $156 billion. This decline of 6.6 percent from the second half of 1991 reflects a reduction in swaps involving the U.S. dollar and the Japanese yen. Over the past several years, a number of changes have taken place in the market for currency swaps, mirroring those in the interest rate swap market.56 For example, the share of interbank business increased to 28 percent at end-1991 from 19 percent at end-1987, whereas the weighted average maturity of interbank currency swaps declined to three years from about six years. At the same time, the share of currency swaps arranged between nondollar currencies rose from 11 percent to 28 percent.

The OTC markets also include caps, floors, collars, and swaptions.57 At end-1991, the aggregate notional value of these instruments stood at $577 billion, an increase of 28 percent from end-1989 (Tables 6 and A4).58 In this total, the notional principal of caps outstanding amounted to $317 billion, of which about 40 percent was accounted for by interbank positions. The notional value of new contracts agreed in the first half of 1992 was $294 billion, 60 percent higher than new activity had been in the second half of 1991.

Exchange-Traded Derivatives

The most actively traded financial derivatives on organized exchanges are futures on interest rates. Trading volumes in these instruments totaled 234.5 million contracts in 1991, up 61 percent from the 1987 figure (Table 8). The bulk of this activity is concentrated in U.S. Treasury bonds and three-month Eurodollar futures (Table A5). However, trading volumes in the notional French Government bond—Obligations Assimilables du Trésor (OAT)—and German bond futures have increased significantly in recent years. Interest rate options and options on interest rate futures are also actively traded on organized exchanges. The volume of interest rate-related option contracts traded worldwide totaled 50.8 million in 1991, up from 29 million in 1987.

Table 8.Annual Turnover in Derivative Financial Instruments Traded on Organized Exchanges Worldwide(In millions of contracts traded)
Futures on short-term interest rate instruments16.429.433.770.275.884.8
of which:
Three-month Eurodollar112.423.725.246.839.441.7
Futures on long-term interest rate instruments74.6116.3122.6130.8143.3149.7
of which:
U.S. Treasury bond254.669.473.872.878.269.9
Notional French Government bond31.111.912.415.016.021.1
Ten-year Japanese Government bond49.418.418.819.116.412.9
German Government bond50.35.39.612.4
Currency futures19.720.822.127.529.129.2
Interest rate options and options on interest rate futures22.229.330.539.552.050.8
Currency options and options on currency futures13.
of which:
in the United States122.9161.4165.3198.1205.7199.7
in Europe9.827.232.649.061.084.2
in Japan9.418.318.823.733.630.0
Source: Adapted from Bank for International Settlements (1992b), p. 55.

Traded on the Chicago Mercantile Exchange-International Monetary Market (CME-IMM), Singapore Mercantile Exchange (SIMEX), London International Financial Futures Exchange (LIFFE), Tokyo International Financial Futures Exchange (TIFFE), and Sydney Futures Exchange (SFE).

Traded on the Chicago Board of Trade (CBOT), LIFFE, Mid-America Commodity Exchange (Midam), New York Futures Exchange (NYFE), and Tokyo Stock Exchange (TSE).

Traded on the Marché à Terme International de France (MATIF).

Traded on TSE, LIFFE, and CBOT.

Traded on LIFFE and the Deutsche Terminbörse (DTB).

Source: Adapted from Bank for International Settlements (1992b), p. 55.

Traded on the Chicago Mercantile Exchange-International Monetary Market (CME-IMM), Singapore Mercantile Exchange (SIMEX), London International Financial Futures Exchange (LIFFE), Tokyo International Financial Futures Exchange (TIFFE), and Sydney Futures Exchange (SFE).

Traded on the Chicago Board of Trade (CBOT), LIFFE, Mid-America Commodity Exchange (Midam), New York Futures Exchange (NYFE), and Tokyo Stock Exchange (TSE).

Traded on the Marché à Terme International de France (MATIF).

Traded on TSE, LIFFE, and CBOT.

Traded on LIFFE and the Deutsche Terminbörse (DTB).

The most actively traded currency futures and options contracts involve the Japanese yen, deutsche mark, Swiss franc, and pound sterling. The total volume of worldwide trading in currency futures was 29.2 million contracts in 1991, an increase of 40 percent from 1987. In currency options and options on currency futures, global trading amounted to 21.5 million contracts in 1991, up 18 percent from 1987. At the same time, trading volumes in futures and options on stock market indices have tapered off. The volume of trading in these instruments is relatively small compared with that of interest rate and currency contracts.

Derivatives Activities of Banks

The major intermediaries or dealers in the OTC derivatives markets tend to be large banks and securities firms in the United States, Japan, France, the United Kingdom, Germany, and Switzerland (Table A6). Banks have been attracted to dealing in OTC derivatives as a way of expanding the menu of interest rate and currency risk management products that they have traditionally provided to their customers.

Among U.S. banks, a handful of large institutions are the main dealers in OTC derivatives accounting for much of the position taking.59 Bank holding companies with total assets of at least $10 billion hold between 98 percent and 100 percent of the notional value of all positions taken by U.S. bank holding companies in various types of OTC and exchange-traded derivatives. This concentration of activity has been relatively stable since 1990, when data were first compiled. The smaller institutions tend to be end users that typically take on derivatives positions to manage risks associated with their traditional banking activities.

Although the notional amounts serve to identify institutions that are active in the derivatives markets, these figures do not provide a useful gauge of credit exposures. The notional amounts are simply hypothetical principal values used to calculate the contractual cash flows that generate the actual credit exposures. The credit exposure of a derivatives contract is the cost of replacing the contract if the counterparty defaults; in other words, it is the positive market value of the contract, if any. These exposures generally amount to only a small fraction, roughly 2–4 percent for interest rate swaps, of the notional values.

U.S. banks report the replacement cost of interest rate and currency swaps as part of their compliance with the Basle accord. The bulk of the credit exposure is concentrated in ten banks, the aggregate credit exposure of which was $170 billion (17.3 percent of their total assets) at end-September 1992. Relative to the total assets of these banks, their credit exposures ranged from 3.2 percent to 33.4 percent. Moreover, 69 percent of total credit exposure ($117.7 billion) is associated with exchange rate contracts, despite their smaller aggregate notional principal amounts, reflecting the fact that currency swaps involve an exchange of both a stream of interest payments and a principal amount.

Bank participation in markets for exchange-traded interest rate futures and options is also extensive. Banks use these instruments in part to hedge their net OTC derivatives position and their on-balance-sheet interest rate risk. The most comprehensive data on banks’ activities in these instruments come from the large trade reports submitted by futures brokers in the United States registered with the U.S. Commodities Futures Trading Commission (CFTC). They cover the large open positions of both U.S. and non-U.S. banks that transact in U.S. futures and options exchanges.60

With respect to open futures positions, available data indicate that banks are most heavily involved in futures on short-term interest rates, such as the three-month Eurodollar contract (Table 9). At end-December 1992, reporting banks accounted for 35 percent of long open positions and 38 percent of short open positions in contracts on short-term interest rates. Banks accounted for 23 percent of long positions in currency futures and 20 percent of short positions; while in futures on stock market indices, banks held 27 percent of all long positions and 22 percent of short positions.

Table 9.Open Positions in Financial Futures and Options on Financial Futures Contracts Traded on U.S. Exchanges, 1992(In percent of total, end-year data)
Types of ContractDistribution of Positions
Purchases (Long)Sales (Short)
Short-term interest rate123.5611.7164.7311.0626.9661.97
Long-term interest rate24.307.3288.378.1916.3575.47
Stock market index426.570.5072.9311.7810.2977.94
Call options
Short-term interest rate114.8328.8556.3217.4626.0856.46
Long-term interest rate217.7815.4666.767.0918.8674.05
Stock market index40.290.3499.371.1610.7788.07
Put options
Short-term interest rate123.1725.0851.7516.7131.8351.46
Long-term interest rate23.5618.4877.957.6019.5272.89
Stock market index42.942.1794.891.341.0197.65
Source: Commodity Futures Trading Commission (CFTC).

Chicago Mercantile Exchange-International Monetary Market (CME-IMM) one-month LIBOR, CME-IMM Treasury bills, Chicago Board of Trade (CBOT) 30-day interest rate, and CME-IMM Eurodollars.

CBOT Treasury bonds, CBOT 2-year and 6.5 10-year Treasury notes, and CBOT municipal bonds.

CME-IMM Canadian dollar, deutsche mark, Japanese yen, pound sterling, and Swiss franc.

CME-IMM Nikkei, Standard & Poor’s (S&P) 500, and S&P 400.

Source: Commodity Futures Trading Commission (CFTC).

Chicago Mercantile Exchange-International Monetary Market (CME-IMM) one-month LIBOR, CME-IMM Treasury bills, Chicago Board of Trade (CBOT) 30-day interest rate, and CME-IMM Eurodollars.

CBOT Treasury bonds, CBOT 2-year and 6.5 10-year Treasury notes, and CBOT municipal bonds.

CME-IMM Canadian dollar, deutsche mark, Japanese yen, pound sterling, and Swiss franc.

CME-IMM Nikkei, Standard & Poor’s (S&P) 500, and S&P 400.

Available data on banks’ open positions in listed options suggest that banks are major participants in options on short-term interest rates. For example, at end-1992, reporting banks wrote 49 percent of put options on short-term interest rates (Table 9). As far as other option contracts are concerned, non-U.S. banks were active as both purchasers and writers of options on currency futures. But banks were not very active in the market for options on futures on stock market indices.

Management of Risks in OTC Derivative Business61

Although participants in markets for derivative securities are exposed to the same types of risks as in other markets—credit, market, liquidity, and legal risks—there are concerns that the speed at which these markets have expanded and the complexity of many of the instruments have weakened risk management.62 Some of the recent products may not be well understood either by senior management of banks or by supervisors of securities firms. Moreover, these institutions may differ in their expertise at evaluating different types of risks. For example, whereas banks have over time developed considerable expertise in performing credit assessments, securities firms have traditionally specialized in evaluating market risks. Finally, participation in derivatives markets can cause firms to become connected through complicated transactions in ways that are not easily understood, making the evaluation of counterparty risk extremely difficult.

Credit Risk

Credit risk derives from the extension of credit to counterparties who may be unwilling or unable to fulfill their contractual obligations. For derivative instruments the current credit exposure is measured by the positive value, or replacement cost, of the contract (which, as demonstrated above, is generally much lower than the notional value of the contract). For exchange-traded derivatives the evaluation and management of credit risk is facilitated by the design of the market. The pricing of credit exposures is achieved through the existence of a near-continuous market for the contracts and by the requirement that positions be marked to market at the end of each trading session. Performance bonds and maintenance margins provide a degree of protection against default by any one participant, while the reserves of the clearinghouse itself and the access to bank lines of credit by the clearinghouse and members of the exchange provide protection to all members against the failure of any one participant.

In contrast, OTC contracts, especially longer-dated ones, can generate significant credit exposures, and some banks have begun to mark OTC contracts to market and to require periodic margin payments. The measurement of credit exposures in OTC derivatives can be complicated by their specificity. The absence of a market for these contracts makes it more difficult to determine capital gains and losses on a continuous basis. The replacement cost of an OTC derivative is obtained by recalculating the theoretical value of the contract as the parameters of the pricing equation change.

For OTC derivatives such as swaps that do not contain options, the initial replacement cost of the contract is zero, since no payment is made at their inception. However, once the market price of the underlying instrument moves, the value of the contract will change, becoming positive for one party and negative for the other. The owner of a contract with a positive value has a claim on the counterparty and is therefore exposed to credit risk.

Conversely, an option does have a positive value at inception—the premium. Over time, and as the price of the underlying instrument changes, the value of the option changes. However, since the value of the option can never be negative, the purchaser will always have a credit exposure to the contract’s writer unless the option has a zero value.63

The current credit risk of a swap contract is calculated as the present value of the net payments the holder expects to pay and receive over the life of the contract. Similarly, for options, the current credit risk can be measured by pricing the option using standard formulas. However, estimating future credit exposures can be very difficult, since the future value of a derivative contract depends on the future values of the underlying instrument and the interest rate that must be forecast. Therefore, the reliability of the forecast itself adds to the risk factor.

Credit risk is generally managed by establishing exposure limits for each counterparty. The most obvious example is the requirement that counterparties have investment-grade credit ratings (triple B or above).64 A substantially higher credit rating—AA or higher—is typically necessary for institutions that are dealers in the OTC market, in particular for nonbank financial institutions. Owing to concern about their credit standings, three U.S. securities firms—Merrill Lynch, Goldman Sachs, and Salomon Brothers—have recently set up units for their swap business, which have been separately capitalized and organized to qualify for a triple A rating.

Once the decision has been made to accept a particular counterparty exposure, the extent of that exposure must be managed. Dealers typically manage both on- and off-balance-sheet credit limits in a centralized unit for a given market, if not globally, to avoid large exposures for the institution as a whole. The overall credit limit for any one counterparty often reflects the expected return and risk associated with the claims on it, with riskier counterparties tending to pay a higher premium in the form of a wider bid-ask spread to undertake a transaction. In fact, the widely posted quotes for swaps are for triple A counterparties only; those with lower ratings are often given different quotes. However, risk-based spreads are not universal, in part owing to the lack of reliable information about the financial positions of counterparties, especially other dealers with complex derivatives books.65

The bilateral netting of swap contracts provides a mean to curb the escalation of these risks, provided that the provisions are legally enforceable.66 The new 1992 master agreement developed by ISDA provides for both payment netting (to reduce the periodic cash flows associated with swaps) and netting of claims in the event of default. Moreover, in the United States, provisions in recent banking reform legislation and an amendment to the bankruptcy law ensure that agreements calling for the netting of claims in the event of default are legally enforceable. But the legal standing of netting provisions of the new ISDA master agreement outside the United States is not altogether certain. Although ISDA has obtained legal opinions in each of the other Group of Ten countries that the netting provision would be legally enforceable if challenged in court, the agreement has not yet faced such legal challenges.

Market and Liquidity Risks

Market risk refers to an unexpected change in the value of an open position owing to a change in the price of the underlying instrument. Unlike credit risk, market risk is generally managed on a portfolio basis rather than on a counterparty basis.67 This arrangement allows banks to set market risk to any desired level. Since dealers frequently enter into offsetting positions with different counterparties and generally hedge the remaining net position, the sensitivity of the overall portfolio to changes in the price of an underlying instrument can be minimal. Hedging can complicate the management of credit risk through the practice of reducing market risk by taking new positions, rather than by unwinding existing ones. In effect, market risk is managed by taking on greater credit risk.

The most difficult risk to counter is liquidity risk; that is, the risk that the act of selling an existing position in derivatives will have a significant impact on the price. Unfortunately, the demands made on derivative products for the hedging of positions can cause liquidity to disappear suddenly in these markets. In the OTC market, where instruments are tailor-made for a particular group of clients, there is in any event less liquidity than in more homogeneous exchange-traded products. For this reason, market makers with uncovered positions at the end of a day’s trading will cover either by taking opposite positions in the organized derivatives markets or by synthesizing an opposite position by using dynamic hedging techniques.68 The use of such dynamic hedging methods can generate liquidity problems because they often mandate sales of underlying securities when prices fall or purchases when prices rise; this can trigger an avalanche of sales into a relatively illiquid market for the underlying security, thereby collapsing the price or causing a breakdown in trading.69 Thus, liquidity risk puts limits on the reliability of the methods used to control market risk and should generate skepticism over claims that risk control software has eliminated market risk as a matter for concern.

Legal Risk

Legal uncertainties have actually been responsible for the most significant losses to date in derivatives markets and continue to present perhaps the most significant risks. The most prominent example is the defaults by some U.K. local authorities on their swaps contracts.70 A unique feature of this financing of local authorities is their access to fixed rate loans on the finest terms from a government agency, which passed on the Government’s comparative advantage in fixed rate borrowing.71 In addition, since local authorities’ income and expenditures tend to move in line with nominal interest rates, a number of authorities sought to obtain low-cost, variable rate loans by borrowing from the Government at fixed interest rates and simultaneously entering into an interest rate swap to pay a variable interest rate and receive a fixed rate. However, in January 1991, the U.K. local authorities were found by the House of Lords to have entered into the swap contracts without the legal right to do so. Subsequently, defaults by local authorities have resulted in losses to their counterparties.

In the United States, the most important source of legal risk is the possibility that the CFTC would apply the Commodity Exchange Act’s prohibition against off-exchange trading to swaps. Under this act, a futures contract not traded on a designated exchange is illegal. Because swaps have certain of the characteristics of futures, this restriction has raised concern that some OTC derivatives would be judged illegal off-exchange futures. In February 1993, the CFTC established a set of rules to exempt swaps and related derivative instruments from most provisions of the act. These new rules were issued under the expanded exemptive authority received by the CFTC under the Futures Trading Practices Act of 1992.

The new rules place several conditions on the exclusion of these transactions from the Commodity Exchange Act, however. In particular, to qualify for exclusion, the instruments cannot be part of a fungible class of instruments that are standardized, and they cannot be traded on a physical or electronic trade execution system. Moreover, the CFTC had issued a policy statement in 1989 that characterized a swap as an instrument having individually tailored terms, commercial and institutional participants, and the expectation of being held to maturity.

A major source of legal risk is the uncertainty surrounding the legal enforceability of netting arrangements among market participants. Under such arrangements, the exposure arising from multiple derivative transactions is netted. Informal industry estimates suggest that exposure reductions of more than 50 percent are achievable through bilateral netting. In the swaps market, master agreements with netting provisions have come into use in which transactions are automatically netted. Without legal certainty, however, the receiver of a bankrupt counterparty might repudiate the agreement and demand payment on all contracts with positive value (cherry picking), while placing the holders of contracts with negative value among the general creditors.72

Systemic Risk and Public Policy

Regulators have at times raised concerns about the risk of a systemic disturbance arising from the derivatives markets. The rapid growth of activity in derivative instruments has tended to strengthen the linkages between market segments, both within countries and across borders. These links have emerged from the capacity of derivatives to unbundle and reallocate the risks associated with positions in the markets for the underlying instruments. The ability, for example, to hedge the currency risk of cross-border investments using derivative instruments has undoubtedly contributed to the rapid growth of gross international capital flows. The unbundling of risks in the underlying asset markets through the use of derivative instruments, such as the separation of currency risk and interest rate risk in a foreign-denominated bond, also creates opportunities to exploit mispricing across market segments.

The tendency for derivatives to create arbitrage opportunities and to strengthen the linkages between markets has increased the possibility that disruptions or increased uncertainty in these markets might spill over into other derivatives markets and into the cash markets more readily than in the past.73 Indeed, a seasoned observer has noted recently that “the expansion of market linkages, which cut across national boundaries and embrace a wide range of financial and nonfinancial firms, raises concerns about the ability of central banks to contain systemic difficulties should they emerge.”74 Such linkages to other markets were also stressed in the report prepared by the Group of Ten central banks on recent developments in international interbank relations (the Promisel Report).75 In addition, there is concern among regulators that risk in the OTC market is overly concentrated in the hands of a few major market players, that risk is systematically underpriced, and that the financial safety net would have to be expanded beyond the banking system to cover nonbank financial intermediaries.

Considering the phenomenal growth of the OTC derivative markets, the potential for systemic risk, and the fact that this relatively complicated subject is admittedly not fully understood by either senior bank managers or by senior regulators, it is not surprising that questions have been raised about the adequacy of the existing regulatory framework. As one prominent observer stated: “Derivatives have revolutionized finance, but have yet to revolutionize regulation.” That evaluation notwithstanding, several regulatory initiatives are under way to improve the prudential supervision of OTC derivatives activities. Regulators have recently sought to encourage institutions to strengthen their internal risk management practices and to improve oversight of this activity by their senior managements. In addition, regulatory authorities in several countries are currently upgrading their prudential supervision of banks in the area of off-balance-sheet exposures and of improving their overall understanding of derivatives. Several government and private sector studies now under way aim to address this latter shortcoming.

The main efforts to limit the potential for systemic risk aim to strengthen individual institutions through appropriate financial policies and to improve the functioning of payments and settlement systems. Capital adequacy requirements and prudential supervision are the main policies directed at strengthening individual institutions, while the principal initiative in payments systems has been to encourage the development of sound arrangements for the netting of OTC derivative contracts.

The Basle accord established a basic framework for including banks’ off-balance-sheet positions in the setting of risk-adjusted capital requirements, largely by establishing credit equivalent measures of OTC interest rate and currency contracts. Interest rate contracts are defined to include single-currency interest rate swaps, basis swaps, forward rate agreements, interest rate futures and interest rate options purchased, and similar instruments. Exchange rate contracts include cross-currency interest rate swaps, forward foreign exchange contracts, currency futures, currency options purchased, and similar instruments. However, instruments traded on exchanges may be excluded provided they are subject to daily margin requirements. Exchange rate contracts with an original maturity of less than 14 days or less are also excluded.

The accord measures the current credit exposure of a derivatives book as the marked-to-market value of all interest rate and currency swaps that have a positive value. A further allowance is made for future credit exposures as well. The sum of current and potential credit exposures carries a 50 percent risk weight under the accord. If a swap has a remaining maturity of at least one year, the add-on is one-half of 1 percent of the notional principal value for an interest rate swap and 5 percent for a currency swap. If the remaining maturity is less than one year, the allowance is zero percent of the notional principal value for an interest rate swap and 1 percent for a currency swap.

With respect to the bilateral netting of positions, the accord relies on the criterion of whether a liquidator of a failed counterparty has (or may have) the right to unbundle the netted contracts, demanding performance on those contracts favorable to its clients and defaulting on the unfavorable contracts. At the time of agreement on the accord, only netting by novation—folding the accumulated net position into a new legally binding contract—was recognized as satisfying this criterion.76 Recently, however, the Basle Committee on Banking Supervision has proposed revisions to the original capital accord that would allow capital requirements to be applied to net open positions in securities in those countries where netting arrangements are legally enforceable.

Could risk reduction also be achieved by channeling more of the OTC business to the organized exchanges? Margin requirements and loss-sharing arrangements have gone a long way toward eliminating credit risk among members of the exchanges, as well as the risk of spillover from a major default. However, banks that satisfy capital requirements may be as creditworthy as some clearinghouses. Moreover, since banks support clearinghouses and exchange members with lines of credit, the ultimate protection from liquidity risk is the same in both markets. It is generally agreed that capital regulations in the OTC markets ought to establish or maintain a level playing field for competition between the exchanges and OTC. The problem is that it is not entirely clear what “level” means. At the heart of this question is the concern that the massive growth in OTC business has occurred because the obligations of major banks and their liquidity are implicitly guaranteed by the financial safety net.

Whereas OTC contracts—e.g., forwards, forward rate agreements, swaps, options, and caps/floors/collars—are tailor-made by the intermediaries to fit the end users’ needs, exchange-traded contracts—futures and options—have standardized maturity, contract size, and delivery terms, and the exchange itself is the counterparty in each transaction. The most actively traded financial derivatives on organized exchanges are futures on interest rates, primarily U.S. Treasury bond rates, Eurodollars, French Government bonds (Obligations Assimilables du Trésor (OAT)), German Government bonds, Japanese Government bonds, and U.K. short sterling and gilts.

Derivatives allow borrowers and lenders easily to change the risk characteristics of securities, e.g., currency denominations or interest rate structure (floating or fixed, caps), or to create completely new risk positions. For example, a U.S. borrower who would like to obtain floating rate deutsche mark to fund a direct investment in Europe might access the fixed rate U.S. dollar market, but swap the proceeds into the floating rate deutsche mark market and attach a deutsche mark interest cap.

International assets are defined as cross-border plus local foreign currency claims of Bank for International Settlements (BIS) reporting banks.

See Bank for International Settlements (1992b), pp. 50–52, for a more detailed discussion.

See ibid., pp. 52–53, for a more detailed discussion.

The cap is the most important instrument, which sets an upper limit on the interest rate that must be paid on floating rate debt. Conversely, a floor sets a lower limit on the interest rate received. A collar combines a cap and floor to limit the fluctuation of an interest rate to a desired range, while a swaption is an option to enter into a swap agreement.

Data on the notional value of caps, floors, collars, and swaptions have been compiled only since end-1989.

“Large” open positions are defined as positions in excess of a minimum that varies between 100 and 850 open contracts depending on the product.

See, for example, Corrigan (1992).

This is also true, for example, for contracts such as caps, floors, collars, and swaptions, which include options in their design.

According to a survey by the International Swap Dealers Association (ISDA), 91 percent of swaps in the portfolios of its members were investment grade at end-December 1991. For end users that do not have investment grade credit ratings, the posting of collateral is one way to gain access to the OTC derivatives market. ISDA is currently undertaking a project to standardize the documentation for collateralized swap contracts to improve the management of credit risk.

The General Manager of the BIS, Mr. Alexandre Lamfalussy, in remarks before the European Finance Conference, November 24, 1992, called for the standardized disclosure of off-balance-sheet positions. To this end, the International Accounting Standards Board (IASB) is developing standards for the accounting treatment of derivative instruments. In a related development, the Financial Accounting Standards Board (FASB) in the United States has adopted several rules regarding disclosure of off-balance-sheet items. For example, under FASB Statement 107, market values of some derivatives are to be disclosed in financial statements beginning in 1993.

ISDA has estimated that legally enforceable bilateral netting reduces the credit exposures of swaps dealers by 40–60 percent.

For example, if in an interest rate swap a bank agrees to deliver floating rate interest payments and receive fixed rate payments with a client, it will seek a balancing swap to deliver fixed rate payments and receive floating rate payments.

In theory, the price behavior of derivative instruments such as call or put options can be mimicked by that of a specific portfolio of positions in cash and in the underlying securities. Such a portfolio is referred to as a synthetic option. When a position in actual options is balanced by the opposite position in synthetic options, the overall position is perfectly hedged, but maintaining the hedge requires dynamic adjustment of the cash and underlying security positions, hence the term dynamic hedging. For further discussion on dynamic hedging, see Goldstein and others (1993), Annex II.

Alternatively, the models used to produce the theoretical hedge may be invalid. During the September 1992 exchange rate mechanism (ERM) crisis, for example, interest rate volatility was far outside its normal range. Hedging models built on assumptions of low volatility prescribed inappropriate mimicking portfolios for some currency and interest rate OTC options, thereby imposing serious losses on market making banks.

According to the 1992 ISDA Default Survey, U.K. local authorities were the source of almost 50 percent of the $358 million in cumulative losses incurred by dealers over the history of their involvement in swaps. The survey covered approximately 70 percent of swaps dealers.

Bank of England (1991) provides details on the legal status of swaps entered into by the local authorities.

The BIS-sponsored report on netting schemes (Lamfalussy Report) endorses netting as a general risk reduction technique and suggests a speedy implementation of measures to ensure legal certainty.

The potential for such problems was evident in the global stock market collapse of 1987, the bankruptcy of Drexel Burnham Lambert in 1990, and in the 1992 European currency crisis. The market break in October 1987 was perhaps accelerated by trading in stock index futures, as prices in equity markets tended to lag behind those in the derivatives market owing in part to capacity constraints in the former. During the ERM crisis in September 1992, the increased interest rate and exchange rate volatility led to strains in certain derivatives markets, such as OTC options, although the markets generally performed well at that time.

The explosive growth of trading in derivative products and other securities has greatly increased payments traffic through the world’s major domestic and international payments systems. In the past five years, these mounting pressures on payments systems have spurred central banks to implement mechanisms to control associated credit risks. Nonsettlement of a bank’s payment operations in a particular currency would either impose a loss directly on the central bank or trigger a systemic problem. To reduce credit risks, caps can be placed on daylight overdrafts in gross payment systems (systems in which payments messages sent by payor banks coincide with the receipt of good funds by the payee bank) or on daylight net debit positions on net end-of-day payment systems. Such limits have been imposed on the Fedwire and Clearing House Interbank Payments System (CHIPS) in the United States and are planned for the Systéme Interbancaire de Télécompensation—Interbank Teleclearing System (SIT) in France. In addition, some systems have either imposed a partial collateral requirement on net debit positions (CHIPS) or have formally announced intentions to shift to a real-time gross settlement with fully collateralized overdrafts (Clearing House Automated Payment System (CHAPS) in the United Kingdom). The Swiss Interbank Clearing (SIC) system has already shifted to the latter mode of operation. Such changes are still in the planning stage for other countries.

Netting by novation is a bilateral contract under which any obligation to deliver a given currency on a given date is automatically amalgamated with all other such obligations, legally substituting one single net amount for the previous gross obligations in a contract that defines novation.

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