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Abstract
OTC derivatives market is listed among diverse causes of the financial crisis. This paper describes the development of the unregulated derivatives market in the period before and during the global financial crisis which started in 2007. The paper is also concerned with new regulations on the OTC market. The aim of this paper is analysing the OTC market development in view of the financial crisis in the years 2007-2009. The objective of the research is the description of the OTC markets influence on the creation of the recent global financial crisis. The additional purpose of the paper is the assessment of the OTC derivatives development prospects after the financial crisis. This paper also strives to present proposals of supervisory institutions for regulating the OTC derivatives market and the influence of these legislative changes on the market. The OTC market turned out to be a dangerous part of the financial system that could lead to its destabilization. New proposals for financial supervisory institutions in the world lead to regulating this market. Will increased surveillance inhibit the growth of the global OTC market in the future? Will this regulation reduce the OTC market attractiveness for investors and financial institutions? What will be the place of the OTC market in a new reality after the crisis? Keywords: OTC derivatives market, financial crisis, OTC market regulations, OTC market development. JEL Classification: G01, G15, G18.
Introduction
The financial crisis that began in 2007 on the U.S. mortgage market, led to significant turbulence and uncertainty throughout the global financial system. The source of the problems was excessive risk taking associated with the sustained low interest rates and investors' desire to maximize profits. Since 2001, low interest rates in the U.S. have been causing an increase in the number of mortgage loans for housing, resulting in a rapid increase in prices of residential real estate. Demand for such properties in the United States was also driven by a general liberalization in the criteria for assessing a group of lenders, who granted loans to borrowers with poor or bad credit histories. It was associated with increased risk. Such mortgages have been marked by the low initial interest rates, which rose sharply after the initial period, which made them very attractive for consumers establishing a new mortgage. Market subprime loans grew rapidly in response to this growth. Securitization of mortgage loans has also developed rapidly. However, in 2006-2007, interest rates rose and prices of residential properties in the United States declined. As a result, many high-risk borrowers could not refinance their mortgages loans as they did in the past and were faced with having to repay a much higher interest rate. This led to a large number of cases of inability to meet financial liabilities, particularly among high-risk borrowers who were not able to cope with such increases. The crisis on the U.S. subprime loans market soon transformed into a global liquidity crisis. This stemmed from the fact that the securitization of mortgage loans caused the transfer of credit risk associated with an increased risk for markets around the world. When the crisis began, no one knew the actual location of the risks associated with securities. This uncertainty concerning the size and location of risk and liquidity constraints caused concern among financial institutions. In addition, the lack of a secondary market for certain securities prompted many financial institutions to revalue their financial assets. Some banks had to make significant write-offs on their balance sheets. There was a risk that the decrease in liquidity caused by the uncertainty on the market would lead to a reduction in credit availability. That happened in the U.S. However, the credit market in the E.U. coped relatively well. Can we talk about derivatives as a cause of the global financial market? Not really. Derivatives are only a tool of financial institutions. These actions have not always been the responsibility which led to the financial crisis. Spreading the risks and obfuscating the picture of the actual level of risk associated with
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derivatives such as CDS (Credit Default Swaps) by financial institutions in connection with raising doubts activities of credit rating institutions led to a speculative bubble on the U.S. market.
Figure 1. Global OTC derivatives markets percentage of types of contracts in the year of 2002
Source: Own work based on: BIS Quarterly Review, International Banking and Financial Market Developments, Bank for International Settlements, December 2004 - December 2010.
In years 2002-2007 the global OTC Derivatives market grew at a rate of approximately 30% per annum. In mid 2008, this market reached 672 bilion dollars and it was the highest level till 2010. Since then, the OTC Derivatives market has been shrinking (by mid 2010 about 15%). The structure of this market during the period was changed. From 2002 until the financial crisis in 2007 the market of OTC Commodity Derivatives Contracts grew (0.61% to 2%), and connected with the foundation of the financial crisis, Credit Default Swaps-CDS rose (from 2.5 in 2004 to 10%). At the same time Interest Rate Contracts market declined (from 70% to 66%). Since mid 2008 there is a noticeable decrease in the CDS on the OTC market. In 2010, the share of these contracts declined (from 10% to 5%). At that time, the market share of equity-linked contracts decreased (from 1.5% to 1%) and Commodity Contracts (from 2% to 0.5%). These decreases resulted in an increasing share Interest Rate Contracts on the market to more than 77%.
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Figure 2. The global OTC Derivatives markets - percentage of types of contracts in the years 2002-2010
Source: Own work based on: BIS Quarterly Review, International Banking and Financial Market Developments, Bank for International Settlements, December 2004 - December 2010.
At the outbreak of the financial crisis a shift in the development of the OTC Derivatives is noticeable. In nominal terms in the second half of 2008 the value of all types of contracts decreased on this market. By mid 2010 the market value was not reconstructed to the state of 2008.
Figure 3. Global OTC Derivatives markets - Gross notional amounts outstanding, in billions of U.S. dollars in the years 2002-2010
Source: Own work based on: BIS Quarterly Review, International Banking and Financial Market Developments, Bank for International Settlements, December 2004 - December 2010.
Credit Default Swaps (CDS) is the OTC Derivatives market instrument. They are directly linked to the rise of the financial crisis in 2007. Figure 4. shows the development of CDS market in the years 2004-2010. Within three years (2004-2007) notional amounts outstanding increased ninefold (from 6.4 to 58 billion dollars). This was a proof of the impending threat of a speculative bubble on the market. At the moment, the market value of this instrument is 30 billion USD. Thus, the market was not completely cleared by the crisis. In 2010 banks and financial institutions are in possession of CDS with a value five times greater than in 2004. Can we therefore say that the situation is stable and there is no risk of further views of the crisis. Probably not.
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Figure 4. Credit Default Swaps market - Gross notional amounts outstanding, in billions of U.S. dollars
Source: Own work based on: BIS Quarterly Review, International Banking and Financial Market Developments, Bank for International Settlements, December 2004 - December 2010.
Figure 5. OTC derivatives development possibilities with new regulations and its consequences
Source: Diego Valiante, Shaping Reforms and Business Models for the OTC Derivatives Market,Quo vadis? ECMI Research Report, No. 5/April 2010, p. 51.
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The recent financial crisis has showed that liquidity is the most important element in the derivatives market. Any intervention to shape their structure should give priority to preserving conditions that allow the market to be deep. The concentration of credit risk due to customised transactions limits the possibility to access the secondary market in case of insolvency problems. Derivatives transactions can be centralised on organised trading venues as long as limited possibilities to customise products do not affect the overall liquidity and flexibility of this market, therefore also affecting centralised clearing platforms, which suffer more than trading platforms from the absence of a liquid market (Valiante D., 2010).
Conclusions
Mysterious and opaque OTC derivatives market since the beginning of the twenty-first century has signaled a growing risk of financial system meltdown. Investors had increasingly polarized their positions until the autumn of 2007 when the financial market broke down. This has not reduced the threat to the system. In fact, it is not correct to blame derivative instruments, lack of central counterparties and the ban on short selling for the collapse of financial markets. According to the Bank for International Settlements, the nominal value of all derivatives in the first half of 2010 amounted to around 580 billion (582 655 000 000 000) US dollars (Bank for International Settlements, 2010), which means that it exceed tenfold the value of the global GDP (International Monetary Fund, 2010). The market of this size cannot be ignored. The preoccupation with increasing regulation of this market in the world is natural. Of course, these treatments on one hand will move part of the transaction to regulated markets by reducing the volume of OTC Derivatives. But this is not the biggest concern. The danger of the proposed changes is to reduce opportunities for businesses to protect their risks in an appropriate manner. Obligatory use of standardized hedging instruments may result in deterioration of security in companies. Moreover, new regulatory changes can increase transaction costs and it will reduce the profitability of these instruments. Supervisors want to restrict the freedom and increase the transparency of the market. These institutions should keep in mind the basic features of derivatives instruments and the consequences of changes in market regulation for non-financial enterprises. It is crucial that market participants should understand the risks associated with the use of derivatives and fairly inform their clients about them. An analysis of the situation on the OTC Derivatives market shows that the development of the OTC derivatives market is threatened in subsequent years. The reaction of markets should be watched closely while implementing the regulations. Regulatory institutions should be prepared for immediate changes in the process of new regulations implementation.
References
1. 2. 3. Downes J., Elliot Goodman J. (2010), Dictionary of Finance and Investment Terms, New York, Barrons., p. 514. Bank for International Settlements (2004), BIS Quarterly Review, International banking and financial market developments, p. A 99. Acharya V.V., Shachar O., Subrahmanyam M., Regulating OTC Derivatives In. Acharya V.V., Cooley T.F., Richardson M.P., Walter I. (Ed.), Regulating Wall Street. The Dodd-Frank Act and New Architecture of Global Finance, John Wiley&Sons, Inc., New York, p. 367. Financial Stability Board (2010), Implementing OTC Derivatives Market Reforms, p. 50-51. Financial Economists Roundtable (2010), Statement of the Financial Economists Roundtable on Reforming the OTC Derivatives Markets, Wharton Financial Institutions Center University of Pennsylvania. Bank for International Settlements (2010), BIS Quarterly Review, International banking and financial market developments, p. A 121. International Monetary Fund (2010), World Economic and Financial Surveys, World Economic Outlook Database, International Monetary Fund, www.imf.org (05.02.2011). Valiante D. (2010), Shaping Reforms and Business Models for the OTC Derivatives Market,Quo vadis? ECMI Research Report, No. 5, p. 51.
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