The OTC Derivatives Market: Risks and Regulations

Manmohan Singh

This article was first published as a chapter in Managing Systemic Exposure, by Risk Books.

This chapter will look at the changing collateral space with a primary focus on the OTC derivatives market. As part of extensive regulatory reform proposals, the introduction of these rules will warrant significant increase in the use of collateral across the financial system. Estimates by markets and research/policy institutions suggest that the Dodd–Frank Act, Basel III and European Market Infrastructure Regulation (EMIR) may necessitate US$2–4 trillion in additional unencumbered collateral that will span margins for OTC derivatives at both central counterparties (CCPs), liquidity ratio(s) under Basel III and related needs stemming from parallel developments under EMIR and Solvency II. At the same time, due to the financial crisis of 2007–09, quantitative easing (QE) and other central bank objectives in the US and Europe, significant amounts of collateral have been drained out of the financial system and siloed at central banks. Furthermore, due to counterparty risk in dealing with large banks and the risk aversion of clients, collateral re-use (or velocity) has also been decreasing.¹¹It