Policy Perspectives on OTC Derivatives Market Infrastructure

by R. Christopher Small, for The Harvard Law School Forum at Harvard Law School, Febraury 10, 2010.

In our paper Policy Perspectives on OTC Derivatives Market Infrastructure (Federal Reserve Bank of New York Staff Report No. 424), we address market design weaknesses in the over-the-counter (OTC) derivatives market that were identified through the crisis, and discuss how the New York Fed and other regulators could improve the structure of this market.

In the wake of the recent financial crisis, OTC derivatives have been blamed for increasing systemic risk. Over-the-counter derivatives markets are said to be complex, opaque, and prone to abuse by market participants who would take irresponsibly large amounts of risks. Although OTC derivatives were not a central cause of the crisis, we find that weaknesses in the infrastructure of derivatives markets did exacerbate the crisis. As a result of failures of risk management, corporate governance, and management supervision, some market participants took excessive risks using these instruments. The complexity and limited transparency of the market reinforced the potential for excessive risk-taking, as regulators did not have a clear view into how OTC derivatives were being traded. If used responsibly, however, over-the-counter derivatives provide important risk management and liquidity benefits to the financial system as well as non-financial corporations and other market participants…(continue reading)

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