Reforming the OTC Derivatives Markets
The recent financial crisis has focused much attention on our financial institutions and markets, and a major subset of this scrutiny is on the role of derivative securities such as credit-default swaps. These contracts were not the cause of the financial crisis. Rather, many observers trace the crisis to such roots as the housing price bubble, excessive leverage, and the concentration of real estate and other risks within the financial system. Still, as illustrated dramatically during the crisis, derivatives can play a key role in reallocating and transmitting risk, including risk that becomes systemic within the financial system.
One of the main causes of systemic risk is the uncertainty about the financial situation of one’s potential trading partners. In periods of market uncertainty, such as at the height of the recent financial market crisis, this uncertainty limited the willingness of financial firms to transact with one another, thereby restricting available liquidity in the marketplace. This restricted liquidity followed from uncertainty about the trading positions of others and to a degree, uncertainty about the pricing of those positions. In addition, the importance of inadequate capital underlying derivatives positions, as illustrated by AIG’s handling of its long-term exotic book, has been an important theme to emerge in the aftermath of the crisis.
