Role of Otc Derivatives in Triggering the Global Crisis: Analysis and Recommendations

Chapter 1 Introductions of the essay

In this essay, firstly, our main objectives are to comprehend the definitions of the OTC derivatives instrument and financial crisis, get acquaint to the OTC instrument and markets, at the same time appraise the role of OTC derivatives in triggering the crisis. The financial crisis which shocked the whole world is indirectly caused by CDS (Credit Default Swaps), one kind of swaps which belongs to OTC derivative instruments. In the real world case, people purchase the CDS in the purpose of reducing the risk of defaults on mortgages, sub-prime mortgages, particularly. The sellers of the CDS that preserved against defaults reduced the risk by changing to buy CDS that paid when the default occurs. When the risk of default rises, the cost of the CDS protection rises. In this way, AIG, which dealt with the CDS market, and Bear Sterns and Lehman Brother as well, played a central role in affecting the entire global financial system and become a potential element of the crisis.

What's more, we'll estimate the OTC derivatives regulatory structure and appraise it critically. The OTC derivatives can somehow incur the crisis is because there are lack of or no counterparties to regulate them, namely, the regulatory framework has some faults on oversight those markets. That's why the risk of OTC contracts can accumulate and flood out of the leverage and become a key role of triggering the shock.

In the end, this essay will set USA as an example and presents their recent actions on improving the structure of regulatory over the OTC derivatives market, so that give advices for other countries to better their OTC market, meanwhile give some recommendations on regulating the OTC markets in order to prevent future crisis.

Chapter 2 Derivatives market and OTC instruments

The derivatives are those contracts whose values are relevant to the price of specific objects, rate, assets, index, etc of an event. And the derivatives can be referred to "financial instrument" which we familiar with. They can be traded exchanges and OTC. Exchange-traded is an instrument that pit trading through open outcry by brokers instead of dealers. It recently have involved in the e-trading platforms, which match the offers and bids automatically instead of manually. Over-the-counter (OTC) derivatives is that non-standardized financial derivatives which are traded directly between market participants (over the counter) but not on a stock exchange.

There are 4 kinds of derivative instruments: futures, forwards, options as well as swaps. It must be noted that the latter 3 are mainly belong to OTC.

1. Forwards. A forward contract represents an agreement between two parties to purchase or deliver in a particular asset at a pre-agreed future period. So, the trading and delivering date are separated. Forward contracts are generally not standardized.

2. Options. An option is an instrumental contract that offers the holder with the right instead of the obligation to buy (call option) or sell (put option) a particular amount or value of specific interest at an underlined price or even expiration date.

3. Swaps. The swap is a contract between two parties which offers cash flow exchanges based on notional amount for a specific period.

It must be noted that there is one important credit derivative which belongs to swap called the Credit Default Swaps (CDS). It is a principle instrument which the participants pursue several objects such as take positive or negative credit views on specific reference entities or let the lender hedge the exposure to credit loss. It is an important tool for measuring and diversifying credit risk. However, in real world case, the fact is that CDS actually increase the overall system risk.

Chapter 3 Financial crisis and the origins

Financial crisis means that the case in which the liquidity is quickly evaporated owing to the money supply exceed the demand, causes the available money is withdraw from financial institutions, forcing financial institutions either to sell their investment to meet the shortfall or collapse.

The financial crisis, what have been affecting the world's economy from the second half of 2007 into the 2008, even till 2009, caused not only the fallen of the stock market all over the world but also the collapse of numerous financial institutions. Even the government of the wealthiest country should take actions to rescue its financial system.

Before explore the origins of the global financial crisis, to get and see how the financial crisis burst out is of great significances. As mentioned in the definition, the financial crisis is somehow causes by the banking behavior, which shows the importance of the bank choices. So, let's discuss the choices made by banks (or financial institutions) first.

Anil Kashyap, Raghuram Rajan and Jeremy Stein (2008) illustrated that the main causes of the credit crisis (as distinct from the housing crisis) which is a key role led to financial crisis was the interplay between the two alternatives: huge amount of mortgage-backed of securities such as subprime risk that transfer risk to those better bearer as well as furnish these and other risky assets with short-term market borrowings. But defects have been proved for this combination because as the housing deteriorated, it become tough to roll over the short-term loan again the mortgage-backed securities as their risk increase. All of these force the banks to sell their assets which they could no longer finance and suddenly the value of these assets deteriorated. What's worse, some of them were even below their fundamental values. Bank funding difficulties exceeded the bank borrowers, as banks cut back on loans to conserve liquidity, thereby made the whole economy shrunk and boosted the global financial crisis.

To look into the reasons of the crisis, what are the roots what visibly trigger the recession which swept to the whole world? Adrian Blundell-Wignall and Paul Atkinson (2008) noted that the global financial crisis was caused at two levels: the global macro policies which affecting the liquidity as well as the poor regulatory framework which is indeed a second line defense. The banking policies all over the world, for instance, the 1% interest rate in USA, helped to accumulate the pressure of overflowing in liquidity which makes the bubble assets exceed the leverage. The regulatory system, acted as a dam, did have faults itself on some specific area, such as mortgage securitization and off-balance sheet activity, which lead to the "dam" breaking down. Those were the origins for the financial crisis.