Over-The-Counter trading of derivatives—financial instruments that are linked to, among other things, other securities, indices, indicators, commodities, and even other derivatives—caused, or at least exacerbated, the recent global financial crisis, according to one popular but far from universally accepted story line.
But whether or not over-the-counter derivatives were a major culprit in the global crisis, few analysts would disagree that these markets—where the instruments are traded directly between two parties rather than on an exchange—have grown so much in size and importance that they need to be brought into the open and more tightly regulated.
At their 2009 Pittsburgh Summit, leaders of the Group of 20 advanced and emerging market economies (G20) called for a major overhaul of these markets, which was to have been completed by the end of 2012. The reforms are supposed to make derivatives trading safer and more transparent (by enabling authorities and investors to gauge buildups of pressure that could spill out and cause broader financial problems).
But more than two years after the deadline, no jurisdiction has fully implemented any of the reforms, and some countries haven’t even started. The reforms backed by the G20 include changing the way each side (collectively called the counterparties) in most derivatives contracts deals with the other. Instead of a purely bilateral relationship, the G20 want one in which a central counterparty is interposed between the two parties in a process called central clearing. The G20 also called for moving over-the-counter trading in many derivatives to exchanges or electronic trading platforms (Internet-based systems for trading financial instruments). For contracts not centrally cleared, G20 leaders proposed higher bank capital requirements.
The reforms have been delayed in many cases because the legislative and regulatory processes required to implement them—including cross-border coordination—turned out to be more complex than anticipated. Some countries are hanging back until Europe and the United States make and mesh their reforms. This article assesses the status of the reform process and the cross-border frictions that have arisen.
Bank for International Settlements (BIS), 2014, “OTC Derivatives Market Activity in the First Half of 2014,” Statistical Release (Basel).
Financial Stability Board (FSB), 2014a, “OTC Derivatives Market Reforms: Eighth Progress Report on Implementation” (Basel: Bank for International Settlements).
Financial Stability Board (FSB), 2014b, “Feasibility Study on Approaches to Aggregate OTC Derivatives Data,” Consultation Paper (Basel: Bank for International Settlements).
Gregory, Jon, 2014, Central Counterparties: Mandatory Central Clearing and Initial Margin Requirements for OTC Derivatives (Hoboken, New Jersey: Wiley Finance).
International Monetary Fund (IMF), 2010, “Making Over-the-Counter Derivatives Safer: The Role of Central Counterparties,” Global Financial Stability Report, Chapter 3 (Washington, April).