Working Paper: NBER ID: w4801
Authors: Michael R. Darby
Abstract: Over the last decade dealing in derivative financial instruments (basically forwards, futures, options and combinations of these), particularly in the over-the-counter (OTC) derivatives market has become a central activity for major wholesale banks and financial institutions. Measured in terms of notional principal amount, OTC derivatives outstanding are near, if not greater than, US$10 trillion, even after deduction of double-counting for intra-dealer transactions. Major new regulatory initiatives, including proposed new capital requirements, are under consideration as a means of reducing systemic risk. This paper examines the concept of systemic risk -- that failure of one firm will lead to the failure of a large number of other firms or indeed the collapse of the international financial system. Alternative proposed definitions are considered and integrated and the effects of OTC derivatives on these risks discussed. The key conclusion is that systemic risk has been reduced by the development of the OTC derivatives market due to shifting economic risks to those better able either to bear the risk or, in many cases, cancel it against offsetting risks. The implications of the Basle II capital proposals for systemic risk are analyzed and shown to increase this risk due to encouraging transactions which increase portfolio risks of the dealers and discouraging transactions which decrease their portfolio risk.
Keywords: OTC derivatives; systemic risk; financial regulation
JEL Codes: G15; G18
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| OTC derivatives (G19) | systemic risk (E44) |
| OTC derivatives (G19) | risk profile of financial institutions (G21) |
| risk profile of financial institutions (G21) | systemic risk (E44) |
| OTC derivatives (G19) | concentration of risk among dealers (G24) |
| concentration of risk among dealers (G24) | systemic risk (E44) |