White Paper: OTC Derivatives Reform


This paper examines the vital role of derivatives in the capital markets, reviews the regulatory initiatives in global financial capitals that will address weaknesses in the OTC derivatives market by changing how they are traded and cleared, which will drive new connectivity requirements for the market’s key players.



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INTRODUCTION

History is full of examples of crises triggered by unregulated derivatives trading. During the Dutch Tulip Mania of 1637, a huge bubble took place where derivative futures in tulip bulbs were swapped at exceptionally high prices until a spectacular collapse left many investors in poverty. In 2008, the demise of Lehman Brothers as well as the inability of AIG to meet its obligations to pay investors to whom it had sold credit default swap insurance unleashed a tsunami that shook the foundations of the global financial system and underscored the systemic importance of OTC derivatives. The global financial crisis drew widespread attention to serious inadequacies in the OTC derivatives market and the risks these contracts present to the broader economy.

This paper examines the vital role of derivatives in the capital markets, reviews the regulatory initiatives in global financial capitals that will address weaknesses in the OTC derivatives market by changing how they are traded and cleared, which will drive new connectivity requirements for the market’s key players.

THE PIVOTAL ROLE OF DERIVATIVES IN THE CAPITAL MARKETS

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Derivatives offer significant benefits to the global capital markets such as aiding price discovery, managing risk, adding to liquidity, improving market efficiency for the underlying asset and reducing market transaction costs. The three primary users of derivatives are hedgers, speculators and arbitrageurs. Hedgers seek to protect themselves from losing money from a given price movement in an asset. Speculators believe they know the future price movement of an asset and back that opinion with money. Speculators provide liquidity to the markets and help fund the positions of hedgers. Arbitrageurs take advantage of price inefficiencies in the market and capture risk-free profits. Like speculators, arbitrageurs also play an important role in the capital markets as their efforts in exploiting price inefficiencies and anomalies keep prices more precise than they would be otherwise. 

The global OTC derivatives market is considerably larger than the exchange-traded derivatives market. According to a report published by the Bank for International Settlements (BIS) in November 2011, the total notional amounts outstanding of over-the-counter derivatives had reached $708 trillion by the end of June 2011. Today, the most heavily traded OTC derivative instruments are interest rate and foreign exchange swaps followed by credit default swaps.

Global policy makers and the leaders of the G20, a group of nineteen major developed and emerging countries plus the European Union, are working to address structural deficiencies in the OTC derivatives market while preserving the benefits they offer. The G20 proposals aim to reduce counterparty risk, increase transparency and protect against abuse in this market. The OTC derivatives market operates on a cross-border basis, with the same products being traded in multiple jurisdictions by multinational institutions. International cooperation and coordination to fulfill enforcement and supervision responsibilities are crucial to minimizing the potential for regulatory arbitrage.

For nearly four decades, IPC Systems, Inc. has created trading communication systems that deliver innovative trading technologies and connectivity solutions to financial market participants.