Over-the-counter (OTC) derivatives, especially credit derivatives, have been at the heart of the financial crisis. OTC derivatives were seen as opaque instruments that, under the guise of hedging, actually served to increase leverage manifold in the financial system.
Some said that these instruments provided the tsunami of liquidity that swept up asset prices during the boom years of 2003-07.
Graphics: Sandeep Bhatnagar / Mint
Others called the explosion of OTC derivatives an indicator of a nefarious “shadow banking system”. One rather plausible forecast was that OTC derivatives would shrink after the crisis and, with them, liquidity too would diminish.
The Bank for International Settlements (BIS) provides data on the notional amounts outstanding in the global OTC derivatives market on a half-yearly basis, and its numbers for the half-year ended June 2009 have recently been published.
BIS defines nominal or notional amounts outstanding as the gross nominal or notional value of all deals concluded and not yet settled on the reporting date.
This provides a measure of market size, but such amounts are generally not those truly at risk. The data show that the grand total of notional amounts of OTC derivatives outstanding amounted to $604.622 trillion (Rs28,115 trillion today) at the end of June.
This was 10.5% more than the $547.371 trillion outstanding at the end of last December. This was after a sharp 20% fall in total notional amounts outstanding during the second half of last year, as the financial panic took its toll.
Simply put, OTC derivatives are making a come-back, although they are still to regain the heights they reached in June 2008.
Credit default swaps, however, continue to shrink, with notional amounts falling to $36.046 trillion at the end of June 2009, a decline of 14% over the half year. During the six months to end-December 2008, they had fallen by 27%. The pace of decline is slowing.
Gross market value of OTC derivatives, which is a better measure of financial risk, fell from $32.2 trillion at the end of December to $25.372 billion at end-June 2009. The decline is due to lower market prices.
The chart shows the financialization of the global economy as notional amounts of total OTC derivative contracts jumped 210% between June 2004 and June 2008.
Notional amounts for credit default swaps rose from $4.477 trillion at end-June 2004 to $58.244 trillion at the end of December 2007, a 1,200% increase. The decline has been far less dramatic. The chart also shows the sharp rise in commodity OTC contracts in the first half of 2008 and its equally sudden collapse.
In short, fears that the crisis would, by affecting OTC derivatives, reduce leverage and liquidity appear to have been misplaced.
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