Page 17 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes The above list is not exhaustive. Several new and innovative contracts have been launched over
the past decade around the world including option contracts on volatility indices.
The OTC derivatives markets have the following features compared to exchange-traded
derivatives:
1. The management of counter-party (credit) risk is decentralized and located within
individual institutions,
2. There are no formal centralized limits on individual positions, leverage, or margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and integrity, and
for safeguarding the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s
self-regulatory organization, although they are affected indirectly by national legal
systems, banking supervision and market surveillance.
Some of the features of OTC derivatives markets embody risks to financial market stability. The
following features of OTC derivatives markets can give rise to instability in institutions, markets,
and the international financial system:

1. The dynamic nature of gross credit exposures;
2. Information asymmetries;
3. The effects of OTC derivative activities on available aggregate credit;
4. The high concentration of OTC derivative activities in major institutions; and

5. The central role of OTC derivatives markets in the global financial system.

Notes Over the Counter (OTC) Derivative Contracts Derivatives that trade on an exchange
is called exchange traded derivatives, whereas privately negotiated derivative contracts
are called OTC contracts. The OTC derivatives markets have the following features
compared to exchange-traded derivatives: (i) The management of counter-party (credit)
risk is decentralized and located within individual institutions, (ii) There are no formal
centralized limits on individual positions, leverage, or margining, (iii) There are no formal
rules for risk and burden-sharing, (iv) There are no formal rules or mechanisms for ensuring
market stability and integrity, and for safeguarding the collective interests of market
participants, and (v) The OTC contracts are generally not regulated by a regulatory authority
and the exchange’s self-regulatory organization. They are however, affected indirectly by
national legal systems, banking supervision and market surveillance.
Instability arises when shocks, such as counter-party credit events and sharp movements in asset
prices that underlie derivative contracts occur, which significantly alter the perceptions of current
and potential future credit exposures. When asset prices change rapidly, the size and
configuration of counter-party exposures can become unsustainably large and provoke a rapid
unwinding of positions.
There has been some progress in addressing these risks and perceptions. However, the progress
has been limited in implementing reforms in risk management, including counter-party,
liquidity and operational risks, and OTC derivatives markets continue to pose a threat to
international financial stability. The problem is more acute as heavy reliance on OTC derivatives

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