Four Opinions on OTC Derivatives

According to the Bank for International Settlements ("BIS"), the global market size for over-the-counter ("OTC") derivatives, as of June 2008, exceeded $683 trillion (yes trillion) or $683,725 billion. (These numbers reflect notional amounts outstanding.) Notably, an expanded use of interest rate swaps helped to push non-exchange traded interest rate derivative product outstandings above $450 trillion, a rise of 17% over the last half-year. It would be helpful to know whether, and to what extent, pensions' use of Liability-Driven Investing strategies influenced the numbers. Click to access "Table 1: The global OTC derivatives market."

Since June, a lot has happened in the global market place. Until BIS reports updated figures, it is hard to quantify how various players have responded to increased volatility with respect to their use of OTC instruments such as swaps, options and structured products. One might logically assume that valuation and liquidity concerns will reflect themselves in lower numbers for H2-2008. On the other hand, uncertainty could encourage hedging, in which case both OTC and exchange-traded activity might see a boost.

In the meantime, I asked a few financial market participants for their feedback. Here is what they had to say in answer to the following query.

Do You Think More Regulations Will Inhibit the Use of OTC Derivatives by Institutional Investors?

• A director at a non-U.S. financial organization advises regulators not to throw the baby out with the bath water, adding that "Regulation should be framed to drive generic flows into more efficient 'plumbing' systems, while allowing custom-built trades to proceed when standardized terms don't make sense. Unless the market volunteers solutions, one must fear that knee jerk regulation will fail to differentiate, and therefore deprive end-users access to these undeniably valuable risk management tools."
• Mr. Daniel Chertok, a quant by background, writes that "Any regulation inherently stifles innovation. However, it may deter those who should not be in this business from entering in the first place or encourage someone to rightly exit the market. There is likely to be a loss of liquidity but a drop in defaults should follow. What regulation will not do is eliminate the next bubble that occurs due to reckless derivative trading."
• Mr. Luis Antonio Rangel, commodity derivatives professional and now President of Rockford Brownstone Rangel, thinks that regulation will inhibit use of OTC swaps and other kinds of derivatives by institutional investors. He adds that "the big downturn in this market recently has less to do with fear of regulation and more to do with counterparty risk. Regulators may help to repair the OTC market if their rules: (a) can improve market transparency as relates to how much leverage a particular manager employs (b) shed light on risk exposures to various counterparties across the spectrum. For example, if Company DEF has a plain vanilla swap with Bank ABC but Bank ABC has a complex swap with Hedge Fund XYZ, how is Company DEF potentially hurt if Hedge Fund XYZ goes belly up? (c) improve investors' knowledge of liquidity, especially for instruments that have heretofore been deemed "low risk" and (d) mandate issuers of credit default swaps to reserve capital, in the same way that insurance companies must set aside monies. Too much regulation could push business offshore or impede transactions that, for viable economic reasons, should take place."
• Mr. Patrick Rooney, Business Analyst at Trading Technologies, writes that "Initially, yes, more regulation will freeze OTC trading. As participants adjust to the new environment, the OTC market will flourish as new participants join. There are many misconceptions regarding the complexities and risks involved associated with OTC transactions. A centralized clearing environment is likely to vastly improve things."

Comments

[Prudent Man...:]

How about transparency, strict independent auditing and responsibility with morality. That would be a change for Wall Street and you wouldn't need a bunch of bureaucrats and Congressmen figuring out who to get bribes from to look the other way.

The more regulators and laws.the more bribes it takes to rip off the investor saps. The 1933-1934 Acts give sufficient teeth to enforce publicly traded securities. The Rubin Treasury and Levitt SEC made certain the regulatory agencies were stripped, like the CIA and Intelligence prior to 9/11, so they wouldn't interfere with their own Ponzi Scheme.

2008 Dec 14 11:27 AM

[gdoran:]

This whole area should be illegal. Hopefully, the regulators will see this and eliminate this betting.

2008 Dec 14 12:48 PM

[Fred Voetsch:]

"...one must fear that knee jerk regulation will fail to differentiate, and therefore deprive end-users access to these undeniably valuable risk management tools."

What a load of hoohey! Risk management is sticking to tried and true measures like performing due diligence; requiring a down payment and assuming that the price of anything can and will drop, sooner or later.

We had risk management rules in place that made sense but in the rush to create wealth that doesn't exist, people like this (and Hank Paulson) decided that this time things would be different...seems like we've heard that before.

--Fred Voetsch

2008 Dec 14 01:40 PM

[happysoul77777:]

Derivatives need to be regulated and traded on an exchange. Otherwise, market makers can manipulate prices and crash the markets. When was it the last time you see the broad bond index was down 15% in a weakening economy?

Worse yet, the FASB accountants force the financial institutions to mark their portfolios using these (fair?) depressed prices. Derivative players know that. They use the leverage inherent in the derivatives to crash the market further.

2008 Dec 14 02:16 PM

[DiracMan:]

Has anyone written a history of the growth of the OTC derivatives market over the last ten years?

Where did the technical ideology of this market philosophy come from? Which business schools taught this as a viable model?

It would appear to me that historical knowledge of the Panic of 1907 and the Great Depression and the interrelated "margin call" unwinding mechanisms that caused financial nuclear fission in these events would preclude faith in this structure. What am I missing in looking at it this way?

I think Joe Credit Default Swaps pretty much got it right.
www.youtube.com/watch?...

60 Minutes.
www.youtube.com/watch?...

Anyone here want to rebutt this little video?
www.youtube.com/watch?...

2008 Dec 14 02:41 PM

[lefty37:]

My Comment----WHA'd she say?

2008 Dec 15 06:45 AM