Insuffificient riskvaluation and risk management capabilities
As revealed by the current crisis, OTC derivatives markets have yet another fundamental weakness: they lack sufficient capabilities for comprehensive risk assessment and management. For complex derivatives, the problem is twofold. First, many market participants lack the ability to adequately price and value derivatives and, in some cases, independent valuations by a third party are not available to support them. Second, after having exposed themselves to risks, many do not have sufficient capabilities to monitor and mitigate these risks effectively.29)
As OTC derivatives are sometimes complex and frequently not traded openly, they are inherently difficult to price. In most cases, there are information asymmetries between broker-dealers that issue and trade derivatives and the end-user. Historically,broker-dealers have therefore taken the lead on valuing these derivatives and providing prices to their counterparties. Clearly, this resulted in a conflict of interest, given that broker-dealers stood to gain or lose, depending on their pricing.30)
Derivatives transactions require adequate risk management. While in the case of exchange-traded derivatives risk management capabilities are already institutionalized (e.g. via CCPs), this is not true for most of the OTC market. The crisis has demonstrated that many market participants are not equipped with suitable means for monitoring and controlling risks. The US insurance group AIG is but one example of how substantial derivatives risks can accumulate over time if internal supervision and controlling fail (see AIG case study in the box on p. 15).
Interconnectedness and complexity
While too high bilateral exposures and gaps in risk management can be a problem for individual participants already, the interconnectedness of derivatives market participants adds to that problem and can impact the market as a whole. Where the market is organized on the basis of bilateral counterparty relations, the failure of one single participant can pose a systemic risk to the market as a whole by destabilizing all its direct and indirect trading partners. A significant part of the OTC segment does not have any mechanisms that can absorb such a potential for domino effects.
Participants in the OTC derivatives market are highly interconnected with other market participants. At the time of its bankruptcy, Lehman Brothers’main European subsidiary had open derivatives positions with almost 22,000 counterparties.31) AIG was involved in derivatives dealings with 1,500 counterparties before its bailout.32)
For the largest broker-dealers, it is safe to assume that these figures are even higher. Should one of those large market participants fail, a vast number of parties would be affected, and a chain reaction of negative spillover effects may develop across many of its counterparties.33) If AIG had not been rescued, some of the largest global banks would have stood to lose sums of up to 30 percent of their equity capital.
AIG case study35)
AIG and derivatives:
AIG built up an OTC derivatives portfolio of more than €2.1 trillion through its subsidiary AIG Financial Products. Over the period 2003 to 2005，it became one of the largest providers of credit protection to other market participants through extensive dealings in CDS.
AIG通过其子公司AIG Financial Products建立了超过2.1万亿欧元的场外衍生品投资组合。在2003年至2005年期间，通过CDS的广泛交易，它成为向其他市场参与者提供信用保护的最大提供者之一。
As AIG incurred heavy losses in 2007, its rating was lowered in May 2008. Due to this decrease in creditworthiness, AIG had to post several billion dollars of additional collateral for its OTC derivatives transactions. When AIG faced further rating downgrades in September 2008 and could not afford any additional collateral calls, the Federal Reserve had to step in and rescue the company.
Potential impact of a default of AIG on other derivatives market participants:
At the time of its bailout, AIG had OTC derivatives trades with around 1,500 counterparties (including institutional investors, corporates, a number of US and international state and local governments, and most of the largest global banks). Data on payments to AIG counterparties through the bailout reveals that banks stood to lose in some cases more than 30 percent of their equity capital had AIG defaulted – amounts that would have taken some of them to the brink of default. The lion’s share of these potential losses would have been from OTC derivatives transactions.
Lack of transparency in selected market areas
The derivatives market is often described as being opaque.36) Especially in the case of bilaterally traded derivatives not cleared by CCPs, there is a lack of transparency on their pricing as well as their risk positions. These intransparencies have a destabilizing effect on the market because doubts regarding the creditworthiness of individual counterparties can create a crisis of confidence – a phenomenon broadly observed during the financial crisis when investors faced severe illiquidity in certain products.37)In addition, intransparencies make it extremely difficult for regulators and supervisors to assess risks on an aggregate level and respond accordingly. AIG, for example, managed to build up its CDS portfolio without supervisors noticing its level of risk exposure for a long time.
Both market complexity and insufficient reporting are drivers of intransparency. Bilateral trading implies a vast number of counterparty relations. At the time of its bankruptcy, Lehman Brothers held roughly 134,000 active OTC derivatives contracts.38) Likewise, AIG’s outstanding derivatives trades numbered around 50,000.39) Without central counterparties, which effectively serve to disentangle these relations, it is nearly impossible to gain a realistic view on effective risk positions. In addition, large areas of the OTC market have no reporting requirements – and hence no post-trade transparency.40) In this respect, there are no market mechanisms which ensures timely, independent monitoring of the market and in particular the OTC segment.
Operational inefficiencies and limited legal certainty
Two further aspects have unnecessarily contributed to the risk of OTC derivatives: operational inefficiencies and legal uncertainty. The former is mostly driven by a lack of standardization and automation in existing products and workflow processes. The latter is primarily due to the unregulated nature and bilateral relationships inherent in OTC derivatives contracts.
Frequently, OTC derivatives are handled manually, which can result in costly delays and potential errors. Confirmations that are inaccurate and untimely can cause disputes, and market participants run the risk of not having an up-to-date and accurate view of their risk positions. Backlogs in trade processing leapedto alarming levels as early as at the onset of the financial crisis in 2007.41) While the OTC derivatives industry has tackled many operational issues, there is still more room for improvement. In particular, standardization/automation levels – at 30 percent for equity and 70 percent for fixed-income derivatives – are still low (Exhibit 6).42)
Stand-alone bilateral contracts are inevitably accompanied by legal uncertainty. The main risk is that counterparties cannot legally enforce their claims. In the course of the crisis so far, disputes over the interpretation of certain clauses, such as the validity of collateral agreements 43), have risen dramatically despite the use of so-called “master agreements” for OTC transactions.
29) “[Among banks] there were also many cases where internal risk management was ineffective and where boards failed adequately to identify and constrain excessive risk-taking”, FSA 2009, p. 92.
30) See Wall Street & Technology 2008, Dow Jones 2008.
31) See Lehman Brothers International (Europe) – in Administration 2009.
32) See AIG 2009a.
33) In case of default, these entities would thus most likely have to be bailed out as they are “too big to fail”, meaning that a bankruptcy would have dramatic consequences for the stability of the global financial system.
34) See AIG 2009b.
41) “In July and August 2007, a spike in credit derivatives trades resulted in substantial increases in backlogs of unconfirmed trades throughout the industry”, IOSCO 2009, p. 29; see also Tumpel-Gugerell 2009.
42) See Markit 2009.
43) See Sutherland 2009.