The Law and Regulation of OTC Derivatives: An Anglo-American Comparison and Lessons for Developing Countries

Abstract

Based on different underlying assets and instruments, derivatives are traded in the absence of clearing houses and organised markets. Since they are not exchange-traded, derivatives are not widely understood. In Over-the-counter (OTC) markets, counterparty default risk generates a network of interdependencies among market actors, promotes risk volatility and results in systemic risk. The largest bankruptcy in the US, Lehman Brothers Holdings Inc., was the result of derivatives financing.1 The same OTC financing caused the failure of the Barings Bank in 1990s.2 Presently, an estimated amount of US$604.6 trillion is outstanding from OTC derivatives contracts,3 which is roughly more than ten times of the world GDP (US$57.53 trillion). The inherent lack of transparency in OTC markets impairs price discovery and obviates the efficient markets hypothesis, i.e., the OTC derivatives and the risks associated with them may be priced incorrectly. The aim of this article is to examine the threat of systemic risk posed by speculative OTC derivative financing to financial institutions and the efforts made by the regulators to reduce such risk. A critical and comparative analysis of the Anglo-American approach to regulate OTC derivatives is endeavoured, in order to evaluate how these advanced economies have proven effective in achieving the ultimate objectives of financial stability, certainty and predictability. The Article examines how the financial regulators of these advanced economies have responded to the vociferous public debate about the threats that OTC derivative financing may have on the overall stability of contemporary financial systems. While the threat is the same, there are substantial differences in regulatory approaches and conclusions. The article concludes by showing how OTC derivatives regulations of advanced economies can be applied to emerging financial markets in order to both increase market efficiency and attain financial stability. In addition to the introduction and conclusion this article is divided into four main parts where each part has its own introduction and conclusions. Chapter 2 begins with an introduction to financial derivatives; the derivatives products (contracts) viz. forwards, swaps and options are introduced and their possible uses, i.e., arbitrage, hedging and speculation are explored. Chapter 3 investigates different types of risks associated with derivatives financing and the legal nature of derivatives contracts and concludes with an analysis of the different regulatory approaches adopted for OTC derivatives. Chapter 4 gives a detailed analysis of and compares the OTC regulation in the United Kingdom (the UK) and the United States of America (the US). The purpose is to identify any similarities and differences in these two regulatory approaches that deal with the identical problem of systemic risk posed by OTC derivatives. Chapter 5 begins with the assessment of potential benefits of OTC derivates. After outlining the potential benefits and also the potential risks of the OTC derivatives for the developing economies, the article gives concrete solutions for the developing economies to regulate their OTC financial markets.