The Changing Risk Management Landscape in Derivatives

The credit crisis has forced remarkable changes in the financial industry, with the OTC derivatives market now facing immense scrutiny. Critics remark that the opaque nature of this market increases counterparty credit risk, thus contributing to systemic risk events.

It has been proposed that trades be cleared through central counterparties (CCPs), significantly reducing default risks. The exchange-traded model also offers liquidity and transparency. Thus, there is now an increased recognition of the benefits in moving away from the opaque and bilateral OTC trading methodology.

Key Findings

OTC Derivatives Regulation – Regulatory bodies around the world increasingly favour a move towards cleared contracts. To this end, banks expect capital incentives and the expansion of regulation to more products.

Risk Management – Even with overarching regulation, it is not yet clear whether risk management will need to adapt significantly. At the moment there has not been any significant change in risk management procedures at the banks interviewed by Lepus.

Benefits of Listed Markets – The OTC market is recognised as being flexible, but exchange-traded contracts, coupled with clearing houses offer transparency, and reduced counterparty risk..

Concerns – While the benefits of listed markets are many, banks stated that OTC markets provide the ability to trade complex, illiquid products with low barriers to entry for customers.

Conclusion

Following the demise of Lehman Brothers, counterparty credit risk has become a major concern. Thus, there are prudent reasons as well as regulatory pressures for banks to execute derivatives trades on exchanges or through CCPs. With gradually increasing innovation in exchange-traded products, the popularity of OTC markets may taper in the near to medium term future. However, regulators and market participants must interact continuously to deliver outcomes that are beneficial to the industry, instead of simply reducing its size.

To receive a free copy of this report, please send your name, job title, address and phone number to marketing@lepus.com and we will ask the sponsors of the report to email a copy to you.