Iv over - the - Counter Derivatives Markets

he virulence of the 1998 turbulence in the mature financial markets took market participants and authorities by surprise , and some have acknowledged that they do not fully understand the rapidly changing structure and dynamics of global financial markets. 1 As last year's International Capital Markets report analyzed, a substantial buildup in derivatives credit exposures and leverage contributed importantly to the turbulence. This substantial leverage—LTCM accumulated $1.2 trillion in notional positions on equity of $5 billion—was possible primarily because of the existence of large, liquid OTC derivatives markets. The rapid growth, development, and widespread use of OTC derivatives markets has accompanied the modernization of commercial and investment banking and the globalization of finance, driven by recent advances in information and computer technologies, and has contributed significantly and positively to the effectiveness of global finance and, in particular, of international financial markets. Much has been written about derivatives as financial instruments and about the role of highly leveraged institutions. By contrast, less has been written about the markets for OTC derivatives per se, and the heavy reliance on them by the small group of internationally active financial institutions. This chapter attempts to fill part of this gap. Derivatives bestow considerable benefits by allowing financial risks to be more precisely tailored to risk preferences and tolerances, and they contribute to more complete financial markets , improve market liquidity, and increase the capacity of the financial system to bear risk and intermediate capital. Derivatives instruments, the structures for trading and risk managing them, and the infrastructures for ensuring their smooth functioning play a central role in the smooth functioning of the major financial and capital markets. These instruments and markets have been designed and developed by the internationally active financial institutions that presently derive a large share of their earnings from these activities. These are the same financial institutions that make up the core of the international financial system and have access to financial safety nets. While derivatives instruments and markets have improved the effectiveness of intermedia-tion and finance generally, and are likely to continue to do so, as crises in the 1990s demonstrated , OTC derivatives activities can contribute to the buildup of vulnerabilities and adverse market dynamics in some circumstances. The severity of repeated episodes of turbulence, and in particular the contours of the market dynamics in the aftermath of the near-collapse of LTCM, suggest that OTC derivatives activities are capable …