The War Against Over-The-Counter Derivatives

Derivatives are useful instruments for managing risk. They allow companies to hedge certain types of financial risk, such as their exposure to foreign exchange rates or commodities prices, in the same way that they might enter into an insurance contract to protect themselves from nonfinancial risks, such as theft or floods. If used in this way, derivatives reduce the risks of economic factors and promote economic stability.

However, the explosion of derivatives usage that occurred at the turn of the century was not driven only by increased hedging needs. Too often, derivatives were used as a way of gaining exposure to certain risk assets for the sake of speculation – and in many cases, as a way to arbitrage bank capital rules with a view toward improving the banks’ return on capital. Rather than mitigating underlying risks, the speculative use of derivatives amplified them.

Following the financial crisis, regulators have been keen to limit the systemic threat posed by derivatives. Their attention has fallen on over-the-counter (OTC) derivatives. Unlike the standardized contracts traded on exchanges, OTC derivatives are bespoke contracts offered mainly by banks and tailored to the needs of bank customers. They often lack the simplicity, liquidity, and transparency of exchange-traded contracts, and potentially allow banks to take on large risks that remain opaque to regulators. And, because many of these contracts are between banks, they increase the potential for contagion during periods of stress, thus increasing systemic risk.

The War Against Over-The-Counter Derivatives