Derivatives have a long-standing history as financial instruments for managing financial risks stemming from changes in macroeconomic conditions. They thus represent important risk management tools for companies, authorities and financial institutions as they can be used to manage exposure to interest rate, currency, commodity price or other risks. Globally, the OTC derivatives market volume amounts to USD 600 trillion; nearly 85% of the world’s out- standing derivatives market volume is accounted for by OTC derivatives.
Derivatives range from fully standardised to tailor-made products: fully standardised derivatives are usually traded on exchanges, whereas customised contracts are traded over-the-counter (OTC). Thus, as OTC derivatives markets are generally characterised by flexible and tailor-made products, satisfying the demand for bespoke contracts customised to the specific risks that a user wants to hedge, OTC derivatives often comprise privately negotiated contracts, with only the participants having access to detailed information. In contrast, exchange-traded derivatives, which are by definition standardised contracts, leave a transparent trail in terms of positions, prices and scale of exposures while OTC derivatives markets have historically been largely unregulated with respect to the disclosure of information even though operations in these markets were executed by supervised entities. As a result, information available to market participants and supervisors has long been limited.1
The financial crisis has brought to light many weaknesses in OTC derivatives markets, such as their intransparency, inherent counterparty risks, or the danger of contagion.2 These problems were highlighted by the near-collapse of Bear Sterns, the default of Lehman Brothers and the bail-out of AIG.
To mitigate such risks, collateralisation and counterparty risk management are essential practices, which were already in use prior to the crisis.
In reaction to the financial crisis, there has been an international effort to increase stability in financial markets – including OTC derivatives markets: In 2009, G-20 leaders agreed that all standardised OTC derivative contracts should be cleared through Central Counterparties (CCPs) by the end of 2012 at the latest, while non-centrally cleared contracts should be subject to higher capital requirements. Furthermore, all OTC derivative contracts should be reported to trade repositories. These changes are set to improve the efficiency and transparency of OTC derivatives markets with a view to reducing counterparty and operational risk involved in these markets as well as overall systemic risk.
The regulatory initiatives currently undertaken follow the commitment made by G-20 leaders in September 2009.
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