Should the government intervene in the OTC markets, pros and cons and US versus Canada - Research Paper Example

?Should the government intervene in the OTC markets, pros and cons and US versus Canada? Introduction An over the counter market (OTC) is a decentralized market for securities where market players trade over the telephone and other electronic systems instead of the physical trading on the floor (Poitras 50). Trading occurs through middlemen commonly referred as the dealers who buy and sell securities on behalf of their clients (Williams 29). Securities traded in this market are not listed on the organized stock exchanges such as the Nasdaq Stock market. Some securities that are traded in the over the counter markets include common stocks, bonds, and derivatives such as forward contracts and interest rate swaps. OTC market is conducted through brokers and dealers thus is a negotiated market where trading is carried out through computer systems and telephone conversations (Poitras 61). The securities traded on OTC market are usually small since the issuers have not met the listing requirements. Though Nasdaq trades through a network of dealers, it is not an OTC market but an organized stock exchange market where trading is carried out on the floor (Poitras 73). Each year, billions of dollars are exchanged in the OTC market. OTC market mainly consists of derivative financial assets such as the forward contracts, interest rate swaps and options. The derivative market has experienced a phenomenal growth since 2000. Derivative instruments were designed for the agricultural industry to hedge the farmers against crop failure, or expected price movements. Derivative contracts have been extended to the main sectors of the economy including oil industry, gold markets and financial sector. Derivatives have the potential of hedging against unforeseen risks and price moments but are subject to abuse by greedy investors (Wood 67). The Commodity Future Trading commission has the mandate of regulating the derivatives market including derivatives traded in the stock exchanges. The derivatives traded in the exchange markets account for $ 334 trillion each year meaning the value of the underlying assets involved is also $ 334 trillion. The main derivatives in the exchange markets are options and future contracts. However, most of the derivative instruments do not trade on the exchange markets, but are transacted in the OTC market. Each year, $ 684 trillion of underlying assets are traded in the OTC market where most of the derivative assets traded include the interest rate swaps, currency swaps, credit default swaps, commodity indexes and exchange rate swaps (Madura 90). Derivative contracts have one similar feature since their value depends on the price movements of the underlying asset (Wood 87). The underlying asset may be a physical commodity or a stock market index or the rate of interest prevailing in the market. Derivative instruments such as options, swaps and future or forward contracts lose or gain value as the underlying asset changes in value even though the holder of the derivative may not be the owner of the underlying asset (Madura 117). Millions of business firms use the derivative instruments to manage foreign exchange risks. Firms protect their profitability against the raw material price increase by entering in to a derivative contract that automatically increases in value when price of the raw material increase. For instance, Southwest Airlines managed to purchase jet fuel at lower prices in 2008 when the energy prices were soaring since it had entered in to a derivative position (Madura 198). Generally, there are two categories of derivative contracts. The first is the option contract that providers the option holder the choice of buying or selling the underlying asset over a certain period of time. The other is the future contract, this contract obligates the holder to buy or sell the underlying asset on the expiry of the contract period. All other derivatives such as options and swaps have evolved from the above two derivative contracts. Hedge funds use derivative contracts to make profits from speculation (Palmiter 7). For instance, if the dealer expects the price of the underlying asset to go high in the future, they will purchase the option at a lower price in order to benefit from the value appreciation at the expiry of the option contract. The only risk assumed is the price paid for the option. Likewise, if they expect the price of the underlying asset to decline in the future, the hedge funds will dispose their options at the current price before the expiry period. If investors are not certain about the future price movements of commodities, they can enter in to future contract that enables them to purchase raw materials and securities at a predetermined price regardless of the prices prevailing in the market (Palmiter 2). Derivatives have also been used to speculate and seek profits by speculators. Speculation provides liquidity in the OTC markets since speculators assume the risks faced by the hedgers. The trading activities of both the speculators and hedgers are essential for the markets since it leads to price discovery. Derivative transactions combine available information and expectations about the future changes of prices of the underlying asset to generate a price that acts as the reference for further transactions of the underlying asset. Most derivative assets assume the interest rates, stock index and foreign exchange rates as the underlying asset. (Source: Duffie and Zhu, 2011). Pros and cons of government interventions in OTC market There are many challenges that face the OTC market since it is mainly unregulated. Some of the challenges include ethical issues and greedy trading strategies associated with some market participants. For instance, during the recent financial crisis in 2008, some hedge funds and investments companies created financial assets such as collateralized debt obligations that were most responsible for the crisis. Credit default swaps led to collapse, and bailout of various large financial institutions in the U.S. The OTC market is dominated by few large financial institutions that play the role of dealers. Before the onset, of the recent global financial crisis, the derivative market was robust, and companies could disperse risks by buying future contracts. The derivative market has traditionally been used to promote financial system stability, but the events of 2008 and 2009 cast doubts on extend of government intervention that is required in the OTC market. In the U.S, government interventions require derivative contracts to be cleared by a central clearing house in order to minimize the counterparty risk. Clearing houses guarantee payments to both parties of the derivative contract in case one of the parties default. Clearing houses charge a variation margin to cover any unforeseen losses (Madura 176). According to the proponents of government intervention in the OTC market, clearing houses create transparency since the clearing house will monitor and record trade dealings in the OTC market. For instance, if AIG had posted initial margin and variation margins to its credit default swaps, it could not be able to issue or buy so many derivatives thus the risk of collapse would be minimal. According to proponents of government regulation, options that are traded in the OTC market are volatile contracts with the possibility of making big gains or huge losses from the transactions thus a system of regulating the counterparty risk should be in place. The regulations will lead to more reporting on all the standardized and customized derivative products, thus the regulatory authority will be able to assess the liquidity and default risk inherent in such derivative instruments (Madura 217). The OTC market is mainly dominated by large financial firms that hold massive customer funds, these firms are said to be too large to collapse. Some of the large firms include JP Morgan Chase, Citigroup and Goldman Sachs. In the event of failure of any of the firms, customers lose a lot of wealth. The government has been forced to bail out some of these firms; therefore, stringent government regulation is required in the OTC market. In 2008, there was no statutory authority to ensure all investment banks maintained liquidity and reported their capital base together with the level of leverage. Derivatives pose a great danger to the financial system of any economy (Michie 109). During the recent financial crisis, Bear Stearns’ OTC derivatives counterparties were forced to reduce their exposure when news of the liquidity weakness spread in the market (Michie 98). The counterparties in Bear Stearns moved their positions to other market players by withdrawing their cash collateral thus Bear Stearns was illiquid. This movement distorted pricing of the derivatives since the rate on the interest-rate swaps were higher than similar government bond yield rates (Singh 46). This was an indicator of low credit of the bank loans relative to government bonds. The interest-rate swaps hedges of Lehman Brothers needed a quick replacement, since other dealers in the market were also experiencing financial problems; they were only willing to replace such hedges at swap rates that were below the government bond yield (Michie 76). Most credit derivative dealers went in to liquidity problems. Lehman Brothers was bankrupt; Bear Stearns was purchased by JP Morgan Chase while Goldman Sachs and Morgan Stanley were forced to become commercial banks in order to accept cash deposits from their original status of financial holding companies. According to the previous regulations, a lot of uncollateralized losses were experienced in the OTC market due to lack of mandatory and standardized margin requirements in the derivative market. For instance, AIG issued about $ 1.8 trillion of credit default swaps on the toxic mortgage backed assets in the event of default without any initial margin due to its high credit ratings. The Federal Reserve was forced to bail out AIG to avert bankruptcy. Finally, government regulation will eradicate the moral hazard problem and unethical behavior in the OTC market. Intervention will reduce instances of soliciting for trade orders and imprudent risk assessment methods that are partly responsible for the recent global financial crisis in the U.S (Madura 198). Government intervention in the OTC market will enhance information sharing since all information on the derivatives traded is centrally available at the clearing house (Duffie and Zhu 74). Availability of information will also narrow the contract spreads thus further reducing the costs associated with hedging. Narrow spreads are essential in ensuring compliance and reducing the instances of counterparty default (Madura 209). Government intervention in the OTC market will limit the positions taken by individual dealers. Large players like JP Morgan Chase will no longer take large positions that have the potential of adversely creating high derivative market volatility. According to proponents of government intervention, buy-side firms that are no members to clearing will be able to access clearing easily. There will be segmentation of the margins of dealers and positions taken, therefore, in case of dealer default such buy-side firms will be able to access clearing. All standard swaps will be executed through a standardized execution facility (SEF) in order to ensure transparency in the OTC market (Madura 239). On the other side, opponents of government intervention in the OTC market assert that clearing houses are expensive process. For every derivative contract in the OTC market, the clearing house must set up standards for the derivative contracts. The process of formulating initial margins, pricing of derivatives and determining the acceptable variation margins is tedious. Proper control and legal regulations are difficult to implement since all the derivatives traded on the OTC market are not standardized (Singh 145). According to the opponents, government intervention will adversely affect the competitiveness of the OTC market due to stringent regulations. Regulations will impact on profitability of investors leading to relocations to other markets that have little or no government intervention (Singh 52). Other opponents of government regulations assert that the supply of underlying assets in the OTC market is unlimited. Supply of the government securities, foreign currencies and other derivative financial underlying assets is usually unlimited. They claim that the OTC market is deep thus it is not possible to manipulate the price of the underlying assets in order to make abnormal profits. They assert the agricultural commodity futures may be out of supply due to the seasonal nature of the underlying asset, but the same regulations should not be implemented in financial supply due to the unlimited nature of supply of the financial securities (Stulz 74). According to the opponents, equity swaps and credit derivatives face limited deliverable supply. Unlike the commodity futures like crop futures where there is high penalties, OTC derivatives penalties are limited to actual damage suffered. Accordingly, equity and credit derivative swaps will not influence the price movement of the underlying securities like the conventional securities, thus speculators and manipulators of the OTC market will not be able to induce the sellers to purchase the underlying asset or offset their contracts at a higher price than the market price (Duffie and Zhu 89). Another argument against government intervention stems from the fact that the prices of the OTC market like the private negotiations of a particular derivative contract are not distributed in the market as a benchmark for pricing other derivative instruments. Counterparties clearly understand the risks involved in the OTC market if they fail to make independent and private valuations of the derivative contract. Counterparties can manage risk exposure by setting their credit limits or using netting and collateral agreements (Stulz 69). US versus Canada Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) are the main statutory bodies that regulate trading in the OTC market in the US. In the UK, derivatives are regulated by the Financial Services Authority (FSA). In the U.S, the Senate enacted the Dodd-Frank Wall Street and Consumer Protection Act of 2010 to deal with OTC derivatives trade. The Act is an example of high level government intervention in the OTC market. Dodd-Frank Act aims at improving consumer confidence and controlling the liquidity level in the OTC markets. All derivatives in the OTC markets are subject to the Act except few that are exempted from regulations. In the US, government intervention covers the registration of dealers in swaps, margin requirements and the execution procedures. Derivatives in the US are regulated by both Security Exchange Commission (Security Based swaps) and CFTC. Both SEC and CFTC require swaps to be cleared by a clearing house regulated by SEC with exemption of swaps for non financial entities that are only used to hedge business risks (Duffie and Zhu 79). Dodd-Frank Act requires all parties to report on swaps to the SEC or CFTC regardless of whether clearing has taken place or not. The Act imposes high margins on swaps and provides for mandatory public access of the transactions volumes and pricing data of the swap dealers. The government rarely intervenes in the OTC market in Canada. Exchange traded derivatives in Canada are regulated by provinces such as British Columbia, Alberta, Ontario and Quebec. Manitoba and Ontario regulations mainly deal with Future contracts and commodity derivatives while Alberta, Quebec and British Columbia have their own legislations to deal with derivatives trade. However, some legislation such as the Quebec Derivatives Act has been enacted to regulate the market though considerable opposition has been witnessed (Birge 517). According to opponents of government intervention in Canada, regulation of the OTC market will hinder market growth and development making it difficult to compete with established markets like the U.S OTC market. However, some market participants have pointed out the need of Canadian Securities Commission to develop an inclusive nation wide framework of OTC market regulation, instead of relying on the current provincial securities regulations such as the Quebec Derivatives Act (Stulz 66). There are certain differences in the government regulations of the US and Canada OTC markets. For instance, in the US, reporting requirements are mandatory for all OTC transactions which are not the case in Canada since non-financial counterparties can only report on the OTC transactions when they exceed the limited threshold (Duffie and Zhu 83). Conclusion The government should intervene in the OTC markets. Derivatives have been used to make massive profits by speculators. The OTC market is essential for the financial stability of the financial system in any country. Government intervention will increase the reporting requirements and level of transparency in the OTC markets. Government intervention through the establishment of regulated clearing houses will reduce the default levels since the clearing houses will guarantee settlement in case of the counterparty default. The Commodity Futures Trading Commission should ensure mandatory clearing. Government intervention will ensure capital and margin requirements are followed in the OTC market. Enough capital should be held against the trading positions in order to reduce adverse systemic risks and further expensive government bailouts. Works cited: Michie, R. The global securities market: a history. Oxford. Oxford University Press. 2006. This book covers the history of securities trading in the US and Canada. It covers the government regulations that are applicable in the OTC markets in those countries. It also touches on the reasons why derivative markets should be regulated. Williams, R. International capital markets: developments and prospects, 2000, developments, prospects and key policy issues. Washington, DC. International Monetary. 2000. Fund. This book covers the regulatory development of the derivative markets in the world. It highlights policies that should be implemented to ensure proper functioning of the OTC market and reduce the counterparty risks. Wood, P. Title finance, derivatives, securitizations, set-off and netting. London. Sweet and Maxwell. 2007. This book introduces the different trading methods in the exchanges markets. It discusses broadly the OTC market trading methodology. The book provides an overview of regulatory authorities in the OTC market and the different derivative securities traded. Palmiter, A. Securities regulation: examples and explanations. New York. Aspen Publishers. 2008. This book discusses the requirements for trading in the OTC markets. Its deals with the functions of the securities market, the main participants and intermediaries in the OTC market. It extensively explains the trading processes in the OTC markets and the happenings of the OTC market during the recent financial crisis. Madura, J. Financial markets and institutions. Mason. Cengage learning. 2010. This book discusses the institutional uses of derivative instruments and trading strategies used by different OTC market players. The book highlights the importance of government regulations in the OTC market. Poitras, G. Risk management, speculation and derivative securities. Boston. Academic Press. 2002. This book discusses the US OTC market and how the dealers are connected to each other. It provides the history of the market for the last 50 years. The book also discusses how derivative securities are executed in the OTC market. Birge, J. Financial engineering. Amsterdam. Elsevier. 2008. The book discusses the procedure of determining the price of the OTC derivatives. The book discusses how complex financial engineering led to substandard collateralized debt obligations during the recent global financial crisis. Stulz, R. “Credit default swaps and the credit crisis,” journal of economic perspectives. Vol. 24 (1): 2009. This Journal discusses how credit default swaps contributed to financial meltdown in 2008. The author claims that CDS were not primarily responsible for the crisis since they were traded on public exchanges. The article shows how financial institutions provided loans to risky individuals who had no chance of repaying them. The Article is essential in the analysis whether government intervention could have resolved the situation in the OTC market. Duffie, D and Zhu, H. “Does a central clearing counterparty reduce counterparty risk,” Economics and social sciences. Vol 1 (1): 2011.74-95 This journal discusses the use of a central clearing house in reducing the counterparty risk in the OTC market. The journal provides for the mechanisms of central clearing system. The journal is useful in analyzing the role of government intervention in the OTC market. Singh, M. “Collateral, netting and systemic risk in the OTC derivatives market,” IMF working paper. Washington, D.C. International Monetary Fund. 2010. In this paper, the paper discusses the need to move from the unregulated OTC market to a central counterparty clearing mechanism. The paper tries to explain the benefits of government intervention like increased transparency and reduced counterparty default. Read More