The purpose of this paper is to determine the role of instruments of over-the-counter trade in triggering the global financial strain, do an analysis of the market and give recommendations. The researcher found out that over-the-counter trade is an established market that is trusted by many lending institutions. That over-the-counter trading thrived at the time when the real estate business was at its peak. Over-the-counter trade also thrived because it is run by key investors in the fiscal sector and as such technically own the fiscal market.
The paper also discusses the operations at the over-the-counter trade with a look at its most popular instrument, the CDS whose collapse indirectly caused the fiscal duress. The researcher also discusses the role of regulators in the collapse of the fiscal market and discovers that one of the reasons is that they did not lay out proper guidelines to gauge the operations of over-the-counter market. The researcher concludes the paper by giving recommendations pertaining to the regulation of over-the-counter trade so as to better the economic sector.
This research is themed; Role of OTC instruments in triggering the global financial crisis: analysis and recommendations. The research begins by describing the origins of the world financial crisis where it analyses how the instruments of the over-the-counter markets contributed to the tumbling of the fiscal sector. The paper will then describe the general over-the-counter trading transactions and the general market. It will give a sneak preview of how the market operates for example how a customer gets into the business and also why over-the-counter markets became a preference to many. This it will do by looking into the most common over-the-counter instrument, the Credit Default Swaps or popularly known as CDS.
The paper will then do a critical evaluation of the role played by OTC derivatives in triggering the economic crisis. It will analyze this role based on the regulatory system, and the market operations. The paper will then dissect the role played by regulatory bodies in fuelling the financial crisis. What did or didn’t they do and also how they governed over-the-counter traders. In the end, the paper will lay out measures that are being taken and that can still be taken to ensure that instruments of over-the-counter trading do not affect the economic crisis anymore. It will give recommendations on what type of regulatory measures should be put down, how the market should be run, if and why it should be closed or not, what types of contracts should be signed, what laws should be put down and what punishments should be rendered in cases where over-the-counter traders do not follow the market policies.
An in?depth analysis of the origins of the global financial crisis
The strain in the sector of finance that began in North America was caused by the collapse of the property ownership business when bank borrowers were not able to pay their loans on time, with world currencies’ depreciation and the overall poor performance in the worldwide financial system. This crisis led to the reflection of whether the administration of the financial institutions and the policies in the global fiscal sector plus their probable disadvantages were responsible for the collapse and if so, how the consequent effect of a recession could be immediately contained. It is the analysis of the above areas that unearthed the existence of the OTC (over-the counter) trade, a bailout opted for by banks after the realization that their capital bases were dwindling-fast. The recession scare led to many banks’ signing of over-the-counter instruments such as the Credit Default Swaps as a way of ensuring that they had savings to fall on in case of instances such as bankruptcy. They did this by signing agreements with middlemen in the over-the-counter trade, who were to bail them out whenever they ran short of money in exchange for their paying premiums (Maryse and Marcos 2009).
How did banks find themselves in this grievous financial dent? To answer this, we have to know where banks get their operational funds. Banks are able to give loans by using money in their reserves or from that which their customers deposit. They also get money by charging interest to the loans they give. According to Maryse and Marcos (2009) Banks incur losses when the security given for a loan is devalued or if no security is given at all. They also incur losses when loans are not paid for on time or are not paid for ever. They also incur losses because the repayment period for the loans is longer than the period in between customer’s depositing money. However, these risks have to be taken if banks are to operate. Trouble began when banks ambitiously gave loans to mortgages companies at a time when the property ownership business was booming. Towards 2006, many financial institutions had come up to help give affordable loans to those who could not meet the high interest charges by the banks. This competition made banks to not only drop their rates in the end but also pushed them to give loans without deposits. In other instances, they allowed a delay in the payment of interests by customers. The combination of ease in getting loans that made many people apply for them, and the availability of derivatives in the over-the-counter trade, plus the good performance of the real estate, that encouraged banks to invest hugely in the over-the-counter trade blinded the world into foreseeing a potential financial crisis (Martin et al. 2008).
Another cause of the calamity in the world financial sector was the laxity by financial institutions to lay out stringent measures that would guide banks and the upcoming financial institutions such as the micro-finance companies in their lending to the public. They also failed to regulate the mushrooming over-the-counter trade that was seemingly seen as a bailout to threats of bankruptcy in case they ever occurred. The shrewd over-the-counter middlemen who offered to pay banks in cases where they lacked finances operated without supervision and proper terms of trade and so it was always a risk to insure with them anyway as many people did not understand how they worked but just developed faith in them. The over-the –counter trade was regarded as bank insurance and were thus thought of incapable to run bankrupt (Martin et al. 2008).
An in?depth analysis of the OTC instruments and markets
The Instruments used in over-counter-trading are not quantifiable and are thus subject to any pricing by financiers who quote prices as suits their risk bases. Some of the over-the-counter derivatives include property swaps, contracts of foreign exchange, and swaps of credit among others. These derivatives were trusted as bailouts to the financial institutions more so banks (Investors’ Working Group 2009, p.16). The most common derivative market is the Credit Default Swap market. In this market, the buyer is the person in a financial crisis whereas the seller is the insurer and the bailout. The buyer and seller sign an agreement with the buyer expected to pay an annual fees to the seller. If the buyer faces a financial dent and needs money then s/he goes to the seller to ask for the same. The seller will only give money if the buyer is able to give a security equivalent to the buyer’s debt. For example if a buyer pays premium worth 200 dollars per month and runs into a debt of about 50,000 dollars, s/he will be paid money required as per the premium rates but only after their giving the seller security equivalent to 50,000 dollars (Europa 2009).
The different instruments include option which Romano (1996) is an agreement that allows owners of assets to trade the assets ahead of an agreed date failure to which the other party keeps it. Other instruments are forwards, credit default swaps popularly known as CDS, and futures. Some of the reasons that popularize CDS trading are: the fact that it has been subscribed to by over 80 percent of banks who invested heavily in them helped build trust as they were considered as legitimate. Also, the overall value of the CDS market was overestimated by financial institutions and other potential buyers who thought that the market dealers were sufficiently capable of rescuing and resuscitating the banking industry and other clientele in case of default. Another reason that made CDS trading attractive is the facts that since the buyers pay premiums to the sellers, the sellers or CDS dealers do not ask for security and so take the risk of running at a loss. These dealers take these risks because most of the times, the money they require to pay as insurance to sellers is normally, a portion of what the buyers pay as premium. Also, it is difficult to quantify Credit Default Swaps. As compared to swaps of interest that are quantifiable hence the terms of trade are clear, the information required to quantify CDS accounts such as statements showing financial position are unreliable. Because of this it is very hard to determine the financial power of a CDS dealer. Also, the CDS dealers operate by downplaying the potential threats that buyers can run into whenever the economy is doing badly and maximizing their prices whenever the economy is doing well (Europa 2009).
CDS middlemen downplay threats so as to assure buyers that the economic situation is not too bad and for buyers to keep having faith in them, and maximize their pricing when the economy is doing well so that they can charge buyers as much premium as that which will help them cover the risks involved in the running of CDS accounts. If a buyer wants to close his CDS account, s/he has to either go to the middlemen who introduce buyers to CDS sellers or sign as part of buyer/seller agreement a consent that s/he will compensate the seller for wanting to quit. Even though by signing an agreement a buyer is seemingly cut off from the seller, the contract remains binding to some extent such that if either the seller or the buyer runs at a loss, then it is the duty of the other to bail them out (Europa 2009).
CDS accounts are operated with minimal transparency as there is a lack of proper regulation so far.
A critical evaluation of the role played by OTC derivatives in triggering the crisis
Even though the OTC instruments might have swindled financial institutions of their money by not dealing transparently, they cannot be attributed as the source of the crisis at the financial market or the recession. The instruments however are said to have further killed the hopes of a quick resuscitation as they contributed to the further draining of the capital bases of banks and companies. OTCs are thought to have led to the near collapse of a famous insurance company that participated in the CDS market. They are thought to have indirectly caused the crisis in the fiscal sector as key players in this market were totally crushed by the impact of the crisis. These companies were instrumental in the derivatives trade as they were either buyers, sellers or both. The companies collapsed when the derivatives trading sector incurred losses due to recession that affected the buyers. Their collapse therefore led to the eventual collapse of the fiscal sector (Europe 2009). It is however said that their contribution to the collapse in the fiscal sector is true to some extent. At the time of their collapse, banks were advised to inter-bank so as to help boost capital but since no bank could trust the other and thus expected either to collapse, the money lenders all fell under the weight of recession (Europa 2009).
Since many banks had faith in the OTCs especially the CDS’ they were vulnerable to their dealings. The operations of the CDS accounts were not transparent and as such CDS customers could not quantify whether it was safe to bank with the CDS or not. When the CDS collapsed, banks followed suit as the CDS’ default meant that banks had lost their investments and consequently their bailout. The banks were naïve in their operations with the CDS middlemen especially by their signing agreements that required either one or the other to pay debts whenever the other defaulted (Martin et. al 2008, p. 29). The rush for mortgages and the move by different financial lenders such as microfinance companies raised the hope of banks’ profit booms and as such made them to confidently pour money in the OTCs. When the recession led to the fall of the property ownership business, the capital of banks reduced drastically, people lost their jobs and thus ran into default. At the same time the risky over-the-counter; CDS business was not able to sustain the demand and collapsed under recession; another cause to financial strain.
CDS trading started from 2 percent in 2001 and steadily grew. By 2006, in the 1st quarter, CDS trading had risen to 25 percent and 35 percent by the second. By the 1st half of 2007, CDS trading had moved to 45 percent and catapulted to 62 by the 2nd quarter. As a result, the toppling of the CDS market automatically brought down with it its investors (International Securities and Derivatives Association 2008, p.33) (refer to appendix i). After about 30 years in the market, over-the-counter trading has become extensive with over two million dollar transactions. The regulators of the financial markets were not keen on the activities by over-the-counter traders who in turn maximized on exploiting their customers. The dealers for example urged customers to invest in the CDS’ whenever the economy was not doing well by lowering their premiums and increasing them sharply whenever the economy was doing well. Such activities were being done without the consent of the regulatory bodies that were then unable to foresee the looming fiscal crisis and eventually recession. The regulatory bodies also asked banks to lower interest rates, a factor that worked against their maintaining their financial reserves and were thus forced to rely on over-the-counter trade. Even though it is easy to blame the regulators, Douglas (2008) argues that the increase in the prices of commodities and unemployment also contributed to the fiscal crisis and as such the bodies did not have a choice but to ask for the rates of interest to be reduced.
A critical appraisal of the regulatory structure (or lack thereof)
Indeed the instruments of OTC and especially the CDS operated without supervision and thus it is no surprise that the regulatory bodies are blamed for the economic plunge. However, some people believe that these bodies did what was best especially given that they believed that flexible terms of operations in the financial sector would improve the performance. It is such freedom that led to the thriving of the derivatives that were mostly deemed capable to sustain their clients in the event of defaults and/or bankruptcy. Scholte (2000, p.3) says that OTC instruments trading is difficult to regulate because they are outlets and alternatives that are set up albeit with risk to help the running of the economic sector and that since they are global, it is impossible for one country to set up operational policies. He continues to say that another reason why it is taxing to regulate these instruments is because their running is subject to a few companies that are on average the major investors in banks and other financial institutions and as such technically hold the cards hence tying the hands of regulators.
However, there are certain measures that are being taken to ensure that the OTCs do not tamper with the economic growth once again. One such measure is by the Commission of Europe that mandates the key instruments to sign a letter of commitment with it so that it can help monitor the transactions of the instruments especially the CDS. The Commission for Europe is presently drafting policies that will help quantify the value of CDS’ and to keep a check on their operations. It has come up with a proposal that it calls the central counter party. This body commonly known as CCP will act as the mediator between the OTC buyers and sellers. It will orient buyers to OTCs trading, advise them on the advantages and disadvantages of OTCs and introduce them to sellers. The standardization policy is meant to help bankers and other over-the-counter customers know how much a dealer has in his or her account so as to ensure transparency. On the over-the-counter seller’s part, the policy will help them be paid by banks in case they run into a default. Moreover, there are consequences if these policies are not followed to the letter (Europe 2009)
The Commission for Europe is insisting that the regulatory body operate from Europe as it would then be easy to monitor the operations and that the body will also work along European regulations and observation. Europeans argue that if CDS’ are monitored in another place, then it will force Europe to depend on other countries to control CDS’ hence they would not be able to aptly contain a potential financial duress. The regulatory procedure is of two types; that are the lawful terms that guide in the conditions of operation, conflict management among others and economic policies that govern areas such as the procedure to develop contracts and the moneys payable to a CDS’ dealers. It is vital to set up these regulations assure customers and decrease the degree of losses as customers are able to have advocacy whenever over-the-counter dealers swindle them. In the past because of lack of governing laws, over-the-counter dealers would not be punished and so were notorious in conning customers (Europe 2009).
Another advantage of the regulations is that they help in quantification and improvement of operational competence. For example, they help the regulatory bodies to calculate security that is payable to CDS by customers whenever they need money. In the past, CDS dealers required their customers to give a security worth the debts that they had before they were given any financial assistance (Europe 2009). Also, banks and other lenders are expected to ensure that customers have security so as to avoid defaulting.
Over-the-counter trading is vital to the economic growth as it has major investors within the financial sector. These investors are important to economic growth as they generate a lot of money into the financial sector that helps in the running of this sector. However, even though over-the-counter investors are also key investors in the fiscal sector in general it does not mean that their running should be haphazard. Stringent measures should be laid out to help bring out transparency and legitimacy in trade so that swindlers are nabbed and that investors do not lose out and cry foul. Other measures that can be taken include steps such as doing online trading since it is more transparent. Online trade will also ensure that trading is faster and will ease the work of regulation as it is easier to monitor the transactions online. Other steps include quickening the process of settlements in cases where a buyer wants to close his or her over-the –counter account. Transactions such as the requirement by customers to give a security equivalent to the amount of debts they have incurred should be revised. Instead, this requirement should be settled on the basis of a net calculation (ICAP white paper 2008, p. 17).
It is advisable to adopt the use of central counter parties who liaise between the buyers and the sellers and ensure smooth running of the over-the-counter market. One of the reasons that make over-the-counter trade risky is the fact that it is difficult to monitor dealers as they trade globally. For this reason the Commission for Europe maintains that it is appropriate if the management of over-the-counter trade was centralized to enable management ease (Coleman 2008, p.3). Lessons learnt as pertaining to over-the-counter trading should be taken seriously so as to avoid the fiscal crisis. Regulators should not hesitate to change policies whenever there are new developments in the market such as over-the-counter traders so as to avoid being caught off guard. Banks should also not give loans to people without security so as to help them not to risk bankruptcy (IMF 2009).
The above measures would help monitor over-the-counter trade help regulators to manage the financial sector in general. This would reduce the number of risks that are encountered within the over-the-counter market.
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