Otc Derivatives - Systemic Risk

Describe the systemic threat posed by OTC derivatives to the financial system. What kind of regulations would you advocate?

The Over- the-counter (OTC) derivative market is the largest market for derivatives, and it is estimated that its value in 2013 reached a level of 700-800 billion dollars, i.e. at least a dozen times more than the GDP over the world. The OTC financing contributed to bankruptcy of Lehman Brothers Holding Inc. in 2008 and Barings Bank in 1990s. Currently, just five banks control 90% of all derivatives contracts, so companies are allowed to gamble on deals made on financial sector. Therefore OTC markets counterparty default risk generates a network of interlinkages and interdependencies among market participants, promotes volatility and lead to systemic risk [Ghouri]. That means the failure of a single entity can cause a cascading failure, which could bring down the entire market.

In terms of regulations of OTC derivatives, the most important issue is greater transparency. After the crisis in 2008 US and UE introduced some OTC market regulations, however it is desirable that United States, the European Union, Japan and other nations will come up with a regulatory regime that works across all borders [Michie, Grieve]. There are two approaches to OTC market regulation. First is an institutional approach, which covers regulation for all financial market enterprises, and the second, functional approach that focused on regulation of financial instruments. The major risk of OTC derivatives can be party avoided by the creation of central clearing counterparties (CCPs) [Singh] and product standardization. In that way central banks or other repositories, to which the parties are required to report open positions and their valuation, will regulate CCPs. What is more the obligation to provide a security deposit by market participants should be implemented. The security deposit would protect against the risk of counterparty default. If there would not be...