In this essay, firstly, our main objectives are to comprehend the definitions of the OTC derivatives instrument and financial crisis, get acquaint to the OTC instrument and markets, at the same time appraise the role of OTC derivatives in triggering the crisis. The financial crisis which shocked the whole world is indirectly caused by CDS (Credit Default Swaps), one kind of swaps which belongs to OTC derivative instruments. In the real world case, people purchase the CDS in the purpose of reducing the risk of defaults on mortgages, sub-prime mortgages, particularly. The sellers of the CDS that preserved against defaults reduced the risk by changing to buy CDS that paid when the default occurs. When the risk of default rises, the cost of the CDS protection rises. In this way, AIG, which dealt with the CDS market, and Bear Sterns and Lehman Brother as well, played a central role in affecting the entire global financial system and become a potential element of the crisis.
What's more, we'll estimate the OTC derivatives regulatory structure and appraise it critically. The OTC derivatives can somehow incur the crisis is because there are lack of or no counterparties to regulate them, namely, the regulatory framework has some faults on oversight those markets. That's why the risk of OTC contracts can accumulate and flood out of the leverage and become a key role of triggering the shock.
In the end, this essay will set USA as an example and presents their recent actions on improving the structure of regulatory over the OTC derivatives market, so that give advices for other countries to better their OTC market, meanwhile give some recommendations on regulating the OTC markets in order to prevent future crisis.
Chapter 2 Derivatives market and OTC instruments
The derivatives are those contracts whose values are relevant to the price of specific objects, rate, assets, index, etc of an event. And the derivatives can be referred to "financial instrument" which we familiar with. They can be traded exchanges and OTC. Exchange-traded is an instrument that pit trading through open outcry by brokers instead of dealers. It recently have involved in the e-trading platforms, which match the offers and bids automatically instead of manually. Over-the-counter (OTC) derivatives is that non-standardized financial derivatives which are traded directly between market participants (over the counter) but not on a stock exchange.
There are 4 kinds of derivative instruments: futures, forwards, options as well as swaps. It must be noted that the latter 3 are mainly belong to OTC.
1. Forwards. A forward contract represents an agreement between two parties to purchase or deliver in a particular asset at a pre-agreed future period. So, the trading and delivering date are separated. Forward contracts are generally not standardized.
2. Options. An option is an instrumental contract that offers the holder with the right instead of the obligation to buy (call option) or sell (put option) a particular amount or value of specific interest at an underlined price or even expiration date.
3. Swaps. The swap is a contract between two parties which offers cash flow exchanges based on notional amount for a specific period.