- Burkhard Drees, Garry Schinasi, Charles Kramer, and R. Craig
- Published Date:
- January 2001
Derivatives markets are central to the functioning of global financial markets, and both exchange-traded and over-the-counter derivatives have improved the pricing and allocation of financial risks significantly. OTC derivatives—compared with exchange-traded derivatives—are flexible and innovative. The ability to use them to unbundle financial risk into separate components is an important step in the direction of creating more complete and efficient financial markets. OTC derivatives enable economic agents to define more precisely their risk preferences and tolerances, and more effectively to manage them. These instruments and the markets in which they are traded support the pricing, trading, risk management, and market conditions in all the major bond, equity, and foreign exchange markets. Probably for this reason alone, they are systemically important, but these markets are also comprised of the internationally active financial institutions that intermediate a large share of international capital flows, and also the lion’s share of global lending, underwriting, mergers and acquisitions, and trading businesses. In effect, the OTC derivatives markets are composed of a complex network of bilateral, asset-price dependent counterparty exposures that intimately bind the world’s largest and most internationally active financial institutions in a very active and fast-paced trading environment at the core of the international financial system.
Modern internationally active financial institutions make significant use of these instruments in part to manage the risks associated with the intermediation and market-making services they provide to clients, but also to manage their own balance sheet risks and to engage in proprietary trading. As Section II explained, in doing so, modern financial institutions are exposed to financial risks that are different, and in some ways more difficult to assess and manage, than in traditional financial intermediation involving on-balance-sheet lending and deposit taking. In effect, the stochastic processes that govern the cashflows associated with OTC derivatives are inherently more difficult to understand, and more unstable during periods of extreme volatility in underlying asset prices. As usual there are tradeoffs, however. Traditional lending and deposit-taking is insulated from some kinds of market risks (but not interest rate risk)—because it records loans at book value—but it runs the risk that the present value of its loan portfolio declines substantially without properly allocating capital to it. Modern institutions, on the other hand, mark positions to market daily for OTC derivatives and thereby have knowledge about their changing risk profiles. But their earning streams are subject to higher recorded volatility and they are subject to more risks associated with market dynamics and liquidity runs in the context of global financial markets.
Unlike the derivatives exchanges, OTC derivatives instruments and markets are essentially unregulated, although they are affected indirectly by national legal systems, regulations, banking supervision, and market surveillance. Nor is the institutional coverage comprehensive, as hedge funds and unregulated securities affiliates are not regulated. Overall, the supervision of financial institutions and market surveillance plays a critical but limited role in ensuring the smooth functioning of OTC derivatives markets, primarily by seeking to ensure the overall soundness of the institutions that comprise them.
Instead an informal framework, relying mostly on market discipline and private voluntary arrangements, ensures smooth market functioning. There are no formal or centralized mechanisms to limit individual or aggregate risk taking, leverage, and credit extension; the pricing and management of the associated risks are decentralized; and each counterpart has its own internal infrastructure for recording, clearing, settling, and managing the contracts over their, at times, long life span. There is no physical or electronic trading platform; instead, the OTC derivatives markets exist on the collective trading floors of the major internationally active financial institutions. Like the strength of a chain composed of separate links, the strength and stability of OTC derivatives markets depends on the strength of counterparties’ risk-management and financial soundness. This is why only sophisticated highly credit-rated institutions are a member of the “club” that make up this informal interbank/interdealer market for trading financial risk.
The OTC derivatives framework has worked reasonably well in not impinging dramatically on the soundness of the major institutions that comprise these markets, in part because they have been well capitalized. But it has not worked well in ensuring market stability, and features of contracts, institutions, and the underlying infrastructure are a potential source of risk, not just of instability in segments of OTC derivatives markets, but also to the international financial system. There were episodes of stress, crisis, and turbulence throughout the 1990s, and the risks of instability were most clearly exemplified in the virulent turbulence and dynamics in the most mature financial markets that accompanied the near-collapse of LTCM in the autumn of 1998. The LTCM crisis created such severe price pressures on the major institutions that risk taking and market liquidity diminished to the point where major central banks perceived the risk of a systemic crisis that could have affected real economic activity.
The crisis revealed a number of surprises. First, the reliance on a combination of market discipline and voluntary mechanisms on the one hand, and official oversight on the other hand, failed to prevent a buildup and concentration of counterparty risks and vulnerabilities. Second, some important features of the underlying financial infrastructure—risk management, and reliance on collateral, closeout procedures, and netting arrangements—did not provide the risk reduction and mitigation results that were expected. Third, before, during, and after the turbulence, there was surprisingly little useful information on which to base assessments about the distribution of risks and exposures among the major financial institutions involved in the market. There was also limited information for assessing the systemic potential of the market turbulence. In short, important features of OTC derivatives markets did not perform as expected when they were most necessary: during a very stressful period in which major firms were at risk of suffering losses and many other smaller institutions were at risk of illiquidity if not insolvency.
Section V identified and analyzed key features of OTC derivatives markets that can give rise to the risk of instability. These include: the dynamic nature of gross credit exposures; important information asymmetries; the fact that OTC derivatives activities affect available aggregate credit and market liquidity; that OTC derivatives markets are large and highly concentrated in the global financial institutions; and the fact that OTC derivatives markets are central to the global financial system. There are also several imperfections in the decentralized infrastructure that were revealed during the LTCM crisis, and which have not yet been adequately addressed: inadequate counterparty risk management; the limited understanding of market dynamics and liquidity risk; and legal and regulatory uncertainty. An additional complicating factor is that the major intermediary and market-making institutions have direct access to financial safety nets, and all of them are too big to liquidate rapidly without risking an international financial market disruption. This potentially imparts an element of subsidy in their pricing of counterparty and other risks that can lead to an overextension of credit and market activity.
The combinations of these risks that were evident in the 1990s can all be seen as originating in imperfections in three broad areas—market discipline, risk-mitigating infrastructures, official rule making and oversight. Improvements are essential if the risk of instability is to be reduced in global financial markets.
Unfortunately, it is easier to identify the sources of instability in OTC derivatives markets than it is to find specific remedies, which can only be pragmatically formulated and implemented by private and official practitioners in these markets. Nevertheless, some broad areas are identified in Section VII as deserving particular attention if market disruptions and instabilities of the kind experienced in the autumn of 1998 are to be avoided. In particular, the private sector can reduce the potential for instability through more effective market discipline, risk management, and disclosure. Public efforts are also necessary, particularly to strengthen incentives for market discipline, remove legal and regulatory uncertainties, and improve the effectiveness of OTC derivatives markets surveillance.
In general, while there are good reasons for public sector involvement (existence of safety nets, legal and regulatory uncertainty, and the potential for systemic financial problems with real economic consequences), this does not mean a heavy hand is required, and a case can be made for relying more heavily on effective market discipline. The markets are dominated by the internationally active financial institutions, and it is in their individual and collective interest to ensure that financial stability is maintained. To achieve this, the balance of private and official responsibility for preventing problems in OTC derivatives markets, and for resolving them, can and should be shifted more in the direction of market discipline.
In order to rebalance private and official roles, it is essential first to clarify the limits to market discipline in OTC derivatives markets (for example, due to private coordination failures and asymmetric information), before leaning more heavily on aspects of market discipline that seem to work well in these markets. This would require a constructive dialogue between private market participants and those with the responsibility for safeguarding financial stability.
Changes in prudential regulations, and in particular capital adequacy requirements, may be a vital pan of this engagement, in part because such changes can further bolster the ability of institutions to withstand the at times strong adverse impact of (shareholder, creditor, and counterparty) market discipline. As noted in the text, even with the 1995 amendment to the 1988 Basel Accord on capital adequacy, there is scope for improving capital adequacy requirements related to credit risks associated with OTC derivatives transactions. The Basel Committee should give serious consideration to ways in which capital charges could more closely reflect the significant changes that occur in a bank’s current and potential future credit exposures when market prices change. In that context, banks’ internal credit risk systems that quantify off-balance-sheet credit exposures (both current and potential) could serve as a basis for appropriate capital charges—subject to verification through an effective supervisory process.
Second, improvements in counterparty risk management, and risk management more generally, are essential. The 1998 turbulence could not have occurred without the buildup and concentration of risk exposures. This resulted from several sources: financial institutions made mistakes; the risk management systems they relied on were not effective in limiting their exposures; and counterparty, liquidity, operational, and legal risks were not properly assessed, monitored, and managed. Implementation of private initiatives in several areas should be accelerated, especially the recommendations of the Corrigan and Thieke report on counterparty risk management.
Third, the quality of disclosure and information needs to be significantly improved. The scarcity of information and its asymmetry was revealed to be an important aspect of the buildup and the unwinding of positions surrounding the LTCM crisis. It is therefore essential to develop mechanisms to make available the minimum information necessary for effective market discipline and for effective official oversight (supervision and surveillance) in a way that assures confidentiality. Thus, while there are challenges in improving disclosure and transparency without creating disincentives for efficient intermediation, more and useful information is necessary, whether through cooperative and coordinated disclosure by the active institutions, or by mandatory disclosure. Likewise, more, and more effective, private counterparty and market monitoring of OTC derivatives markets is essential. This monitoring can be achieved either by creating incentives for the private sector to provide more information on its own or by making sure in some reasonable way that private market participants are not taking imprudent risks.
Fourth, progress in resolving legal and regulatory uncertainly is achievable. Uncertainties about closeout procedures, netting arrangements, bankruptcy, and recapture of collateral have given, and can still give, rise to severe market dynamics during periods of heightened uncertainty about counterparty risk. The interconnected nature and concentrations of counterparty exposures together with legal and regulatory uncertainty make the OTC derivatives markets especially vulnerable to attempts to rapidly unwind large gross exposures, when in most cases resolving net exposures would suffice. It would be useful to reduce some of this uncertainty, but only if it does not inadvertently lead to even greater risk taking. In return for legal and regulatory certainty, the private institutions that created these markets might have to implement changes to the structure of these decentralized markets and infrastructures in ways that reduce the risks of market instability.
Fifth, as noted in Chapter IV of International Monetary Fund (1999), there also were flaws in the official lines of defense against financial problems (banking supervision and market surveillance). While some progress is being made in specific areas (relating mostly to transparency), banking supervision and market surveillance also need to be adapted to monitor more effectively OTC derivatives activities and markets by, for example, paying closer attention to the impact of OTC derivatives activities on private risks within financial institutions and on private and systemic risks within and across markets.
Collectively, these initiatives can both improve the potential benefits of market discipline and bolster the private sector’s ability to avoid and deal with financial problems, and thereby should help reduce systemic risk.