OTC Derivatives

Question 1

Deficiencies OTC derivatives

Answer 1

1. Lack of transparency, opaqueness
2. Significant counter party risk
3. OTC derivatives prices have no market references, calculated internally
4. relatively illiquid
5. Valued by internal parameters, hence increased the difficulty involved in assessing true value or risk exposure by regulators
6. It is a risk accumulating tool, because you can not stop speculators building up systemic risk
7. The issue is recognised but has not been implemented fast enough like capital reserve requirement area

Question 2

Why we need OTC derivatives?

Answer 2

1. It is risk spreading tool, it allows to transfer risk for whoever can afford ( through hedging)
2. OTC are highly customised and specifically tailored for certain risks that are can not be covered through standardised contracts, ie risk management is not a standardised issue therefore cannot be managed through standardised contracts. Natural hedgers dont wish to bear the capital cost increase caused by speculators

Question 3

Potential Improvements on OTC derivative area

Answer 3

1. Simplification of which the way of derivative transactions are done and increase the transparency.
   Ex: requirements of trading reports: AIG
2. Creating a regulatory condition by incentivising any financial institutions which are holding derivatives from CCP instead of OTC, by allowing less capital to hold against CCP derivatives