II Modern Banking and OTC Derivatives Markets

uring the past two decades, the large internation- off-balance-sheet business entails extensions of D ally active financial institutions have trans- credit. For example, a simple swap transaction is a formed the business of finance dramatically. In doing two-way credit instrument in which each counter- so, they have improved the ability to manage, price, party promises to make a schedule of payments over trade, and intermediate capital worldwide. Many of the life of the contract. Each counterparty is both a these benefits have come from the development, creditor and debtor and, as in traditional banking, the broadening, and deepening of, and greater reliance modern financial institution has to manage the cash on, OTC derivatives activities (see Box 2.1: Precision inflows (the creditor position) and outflows (the Finance, Desegmentation and Conglomeration, and debtor position) associated with the derivatives con- Market Integration). Although modern financial insti- tract. But there are important differences. First, the tutions still derive most of their earnings from inter- embedded credit risk is considerably more compli- mediating, pricing, and managing credit risk, they are cated and less predictable than the credit risk in a doing increasingly more of it off balance sheet, and in simple loan because the credit exposures associated less transparent and potentially riskier ways. This with derivatives are time-varying and depend on the transformation has accelerated during the 1990s. prices of underlying assets. Traditional bank lending is largely insulated from market risk because banks carry loans on the balance sheet at book value, mean- The Transformation of Global Finance ing they may not recognize and need not respond to market shocks. Nevertheless, market developments Traditional banking involves extending loans on can contribute to unrecognized losses that can accu- borrowed funds (deposits) of different maturities. mulate over time. By contrast, OTC credit exposures Each side of this ledger has different financial risks. A are subject to volatile market risk and are, as a matter simple loan is for a fixed sum, term, and interest rate; of course, marked to market every day. This creates in return the bank is promised a known schedule of highly variable profit-and-loss performance, but it fixed payments. The risk in lending, of course, is that imparts market discipline and also avoids undetected the borrower may become unable or unwilling to accumulations of losses. Day-to-day shifts in the make each fixed payment on schedule. This is credit constellation of asset prices can have a considerable (or counterparty) risk,2 comprising both the risk of de- impact on credit risk exposures—both the exposures fault (missing one or all payments) and the expected borne by any particular financial institution and the loss given default (that less than is promised is paid). distribution and concentration of such exposures Loans are funded by deposits with much shorter ma- throughout the international financial system. turities than most bank loans, which imparts liquidity Second, the dynamics of modern finance are con- risk. The basic business of banking is to manage these siderably more complex than those of deposit mar- two sets of cash flows, each having a different, sto- kets. Deposit flows have a degree of regularity asso- chastic structure. As the history of bank runs and fail- ciated with the flow of underlying business. By ures indicates, managing these cashflows is inherently contrast, flows associated with OTC derivatives and risky and banking is prone to instability.3 liquidity conditions in these markets, and in related This tendency toward instability does not seem to markets, can be highly irregular and difficult to pre- have diminished in the 1990s, and may have in- dict, even for the most technically advanced dealers creased. In modern finance, financial institutions' with state-of-the-art risk management systems. Overall, the stochastic processes that govern the cash flows associated with OTC derivatives are in- herently more difficult to understand, and seem to be 2See the Glossary for definitions of special terms. 3See Bryant (1980), Diamond and Dybvig (1983), and Kindle- more unstable during periods of extreme volatility in berger(1989). underlying asset prices.

3 II MODERN BANKING AND OTC DERIVATIVES MARKETS

Box 2.1. Precision Finance,Desegmentation and Conglomeration,and Market Integration

The main changes that have characterized the global- • Conglomeration of financial activities into large ization of finance and risk can be summarized in the institutions providing traditional banking, invest- following points: ment banking, insurance, and other financial • Greater use of modern precision finance to unbun- services. dle, price, trade, and manage complex financial • Emergence of internationally active (global) finan- risks. cial institutions (banks, institutional investors, and • Transformation of banking from concentration on conglomerates). lending (leverage and maturity transformation are • More highly integrated markets, with greater diver- traditional definitions of banks), to diversification sity in the quality, sophistication, and geographic into fee- and service-based businesses. origins of borrowers and lenders. • Transformation of balance-sheet activities into se- • Larger exposures to non-home markets. curitized loans and off-balance-sheet positions. • Rapid and continued growth in the importance of The confluence of these changes has been associated institutional investors, and the associated bank dis- with: greater mobility of capital; an accelerated expan- intermediation; institutional investors manage more sion of cross-border financial activity; greater interde- than $23 trillion. pendencies between market participants, markets, and financial systems; greater market efficiency and liquid- ity in international markets; and faster speeds of adjust- *See Annex V in International Monetary Fund (1998). ment of financial flows and asset prices.

Table 2.1 .Top Twenty Derivatives Dealers in 2000 and Their Corresponding Ranks in 1999

Rank Members of Exchanges3

Derivatives Dealers 2000 1999 CME LIFFE EUREX HKFE TSE TIFFE

Citigroup 1 X X X X X Goldman, Sachs & Co. 2 2 X X X X X 1 Deutsche Bank 3 6 X X X X X Dean Witter 4 4 X X X X X Warburg Dillon Read 5 7 X X X X X Merrill Lynch & Co. 6 5 X X X X X J.R Morgan 7 3 X X X X X Chase Manhattan Corp. 8 8 X X X X Credit Suisse First Boston 9 9 X X X X X Bank of America 10 II X X X X NatWest Group II n.a. X X X Lehman Brothers 12 12 X X X X X Hong Kong and Shanghai Banking Corp. 13 16 X X X X X X Societe Generale 14 13 X X X American International Group 15 19 X Capital 16 14 X X X X X X Dresdner Kleinwort Benson 17 n.a. X X X X 2 BNP-Paribas 18 18 X X X X X ABN Amro 19 17 X X X X X 20 n.a. X X X X

Source: Clow (2000), pp. 121 -25. 'Includes BT Alex. Brown for 2000. 2Ranking of Banque Paribas for 1999. 3Chicago Mercantile Exchange (CME); International Financial Futures and Options Exchange (LIFFE); European Derivatives Market (EUREX); Hong Kong Futures Exchange (HKFE);Tokyo Stock Exchange (TSE); and Tokyo International Financial Futures Exchange (TIFFE).

Thus, in addition to assessing and managing the tential change in the value of the credit extended and risk of default and the expected loss given default, form expectations about the future path of underly- the modern financial institution has to assess the po- ing asset prices. This, in turn, requires an under-

4 Importance of OTC Derivatives in Modern Banking and Global Finance

Box 2.2.The Role of OTC Currency Options in the Dollar-Yen Market

OTC derivatives activities can exacerbate distur- of dollar selling, in turn, was viewed as having created bances in underlying markets—even some of the the sentiment that the dollar's long-standing strengthen- largest markets, such as foreign exchange markets. ing vis-a-vis the yen had run its course. But, as in March This was, for example, the case in the dollar-yen mar- 1995, in addition to reversals of yen-carry trades, knock- ket in March 1995 and October 1998; once the yen had out options were widely viewed as having provided ad- appreciated beyond a certain level, the cancellation of ditional momentum that boosted demand for yen and OTC knockout options and the unwinding of associ- contributed to the dollar selling. ated hedging positions fueled the momentum toward Knockout options (a type of OTC barrier option) dif- further appreciation.1 During these periods of height- fer from standard options in that they are canceled if ened exchange rate volatility, OTC derivatives activi- the exchange rate reaches certain knockout levels, and ties also significantly influenced exchange-traded op- therefore leave the investor unhedged against large ex- tion markets, because standard exchange-traded change rate movements. Nonetheless, they are widely options were used by derivatives dealers as hedging ve- used since they are less expensive than standard op- hicles for OTC currency options. tions. In 1995 and 1998, knockout options, particularly In 1995, the yen appreciated vis-a-vis the dollar from down-and-out put options on the dollar, amplified ex- ¥101 in early January to ¥80 in mid-April, strengthen- change rate dynamics through two separate channels: ing by 7 percent in four trading sessions between (1) Japanese exporters who bought knockout options to March 2 and March 7. A combination of macroeco- protect against a moderate depreciation of the dollar nomic factors was widely cited as having contributed sold dollars into a declining market when the knockout to the initial exchange rate move. The speed of the options were canceled to prevent further losses on their move also suggests that technical factors (such as the dollar receivables; and (2) dynamic hedging strategies cancellation of knockout options) and short-term trad- employed by sellers of knockout options required the ing conditions (such as the unwinding of yen-carry sudden sale of dollars after the knockout levels had trades, also involving OTC derivatives) reinforced the been reached (see Box 3.3), Ironically, OTC knockout trend. In early 1995, relatively large volumes of down- options that protect only against moderate exchange and-out dollar put options were purchased by Japanese rate fluctuations can sometimes increase the likelihood exporters to partially hedge the yen value of dollar re- of large exchange rate movements—the very event ceivables against a moderate yen appreciation. they do not protect against. In September-October 1998, the yen again appreci- Although knockout options represented a relatively ated sharply vis-a-vis the dollar from ¥135 to ¥120 per small share of total outstanding currency options (be- dollar. Of particular interest are the developments during tween 2 and 12 percent), they had a profound effect October 6-9, 1998, when the yen strengthened by 15 on the market for standard exchange-traded options. It percent in relation to the dollar. Talk of an additional fis- is easy to see why: knockout options are sometimes cal stimulus package in and a reassessment of the hedged by a portfolio of standard options. Dealers relative monetary policy stances in Japan and the United who employed this hedging technique needed to buy a States may have sparked the initial rally in the yen and huge amount of standard options at the same time as corresponding weakening in the dollar. The initial spate other market participants were trying to contain losses from canceled down-and-out puts. As a consequence, prices of exchange-traded put options (implied 2See International Monetary Fund (1996, and 1998b, Box volatilities) doubled in March 1995 and almost dou- 3.1) and Malz (1995). bled in October 1998. standing of the underlying asset markets and estab- $94 trillion in notional principal, the reference lishes a link between derivatives and underlying amount for payments, and $2.6 trillion in (off-bal- asset markets. ance-sheet) credit exposures (see Section III). The markets comprise the major international financial institutions (Table 2.1), and together the instruments Importance of OTC Derivatives in and markets interlink the array of global financial markets through a variety of channels.4 Modern Banking and Global Finance In the past two decades, the major internationally The unpredictable, and at times turbulent, nature active financial institutions have significantly in- of OTC derivatives markets would merit little con- creased the share of their earnings from derivatives cern if OTC derivatives were an insignificant part of activities, including from trading fees and propri- the world of global finance. They are not, and they are increasingly central to global finance. OTC de- 4See the discussion of spillovers and contagion in International rivatives markets are large, at mid-2000 comprising Monetary Fund (1998a).

5 II MODERN BANKING AND OTC DERIVATIVES MARKETS

Box 2.3. LTCM and Turbulence in Global Financial Markets1

The turbulent dynamics in global capital markets in tal, LTCM had assembled a trading book that involved late 1998 had been preceded by a steady buildup of nearly 60,000 trades, including on-balance-sheet posi- positions and prices in the mature equity and bond tions totaling $125 billion and off-balance-sheet posi- markets during the years and months preceding the tions that included nearly $1 trillion of notional OTC Russian crisis in mid-August 1998 and the near col- derivative positions and more than $500 billion of lapse of the hedge fund LTCM in September. The bull- notional exchange-traded derivatives positions. These ish conditions in the major financial markets continued very large and highly leveraged trading positions through the early summer of 1998, amid earlier warn- spanned most of the major fixed income, securities, ing signs that many advanced country equity markets, and foreign exchange markets, and involved as coun- not just in the United States, were reaching record and terparties many of the financial institutions at the core perhaps unsustainable levels. As early as mid-1997, of global financial markets. differences in the cost of borrowing between high- and Sentiment weakened generally throughout the sum- low-risk borrowers began to narrow to the point where mer of 1998 and deteriorated sharply in August when several advanced country central banks sounded warn- the devaluation and unilateral debt restructuring by ings that credit spreads were reaching relatively low Russia sparked a period of turmoil in mature markets levels and that lending standards had been relaxed in that was virtually without precedent in the absence of some countries beyond a reasonable level. A complex a major inflationary or economic shock. The crisis in network of derivatives counterparty exposures, en- Russia sparked a broad-based reassessment and repric- compassing a very high degree of leverage, had accu- ing of risk and large-scale deleveraging and portfolio mulated in the major markets through late summer rebalancing that cut across a range of global financial 1998. The credit exposures and high degree of lever- markets. In September and early October, indications age both reflected the relatively low margin require- of heightened concern about liquidity and counterparty ments on over-the-counter derivative transactions and risk emerged in some of the world's deepest financial the increasingly accepted practice of very low, or zero, markets. "haircuts" on repo transactions. A key development was the news of difficulties in, Although the weakening of credit standards and and ultimately the near-failure of, LTCM, an important complacency with overall risk management had bene- market-maker and provider of liquidity in securities fited a large number of market participants, including a markets. LTCM's size and high leverage made it partic- variety of highly leveraged institutions (HLIs), ularly exposed to the adverse shift in market sentiment LTCM's reputation for having the best technicians as following the Russian event. On July 31, 1998, LTCM well as its high profitability during its relatively brief had $4.1 billion in capital, down from just under $5 bil- history earned it a particularly highly valued counter- lion at the start of the year. During August alone, party status. Many of the major internationally active LTCM lost an additional $1.8 billion, and LTCM ap- financial institutions actively courted LTCM, seeking proached investors for an injection of capital. to be LTCM's creditor, trader, and counterparty. By Au- In early September 1998, the possible default and/or gust 1998, and with less than $5 billion of equity capi- bankruptcy of LTCM was a major concern in financial markets. Market reverberations intensified as major market participants scrambled to shed risk with LTCM !This box draws on the analysis in International Monetary and other counterparties, including in the commercial Fund (1998b, 1999). paper market, and to increase the liquidity of their posi-

etary trading profits. These institutions manage range of uncertainty, assess the riskiness of expo- portfolios of derivatives involving tens of thousand sures. Risk management systems guide the rebal- of positions, and daily aggregate global turnover ancing of the large OTC derivatives portfolios, now stands at roughly $1 trillion. The market can which in normal periods can enhance the efficient be seen as an informal network of bilateral counter- allocation of risks among firms, but which can also party relationships and dynamic, time-varying be a source of trading and price variability—espe- credit exposures whose size and distribution are in- cially in times of financial stress—that feeds back timately tied to important asset markets. Because into the stochastic nature of the cashflows. each derivatives portfolio is composed of positions Expansions and contractions in the level of OTC in a wide variety of markets, the network of credit derivatives activities are a normal part of modern exposures is inherently complex and difficult to finance and typically occur in a nondisruptive man- manage. During periods in which financial market ner, if not smoothly, even when there is isolated conditions stay within historical norms, credit ex- turbulence in one underlying market. The potential posures exhibit a predictable level of volatility, and for excessively rapid contractions and instability risk management systems can, within a tolerable seems to emerge when credit exposures in OTC ac-

6 Importance of OTC Derivatives in Modern Banking and Global Finance

tions. LTCM's previous "preferred creditor" status curities to meet margin calls, adding to the decline in evaporated, its credit lines were withdrawn, and margin prices. The decline in prices and rise in market volatil- calls on the fund accelerated. The major concerns were ity also led arbitrageurs and market-makers in the secu- the consequences—for asset prices and for the health rities markets to cut positions and inventories and with- of LTCM's main counterparties—of having to unwind draw from market-making, reducing liquidity in LTCM's very large positions as well as how much securities markets and exacerbating the decline in longer LTCM would be able to meet mounting daily prices. In this environment, considerable uncertainty margin calls. As a result, LTCM's main counterparties about how much an unwinding of positions by LTCM demanded additional collateral. On September 21, Bear and similar institutions might contribute to selling pres- Stearns—LTCM's prime brokerage firm—required sure fed concerns that the cycle of price declines and LTCM to put up additional collateral to cover potential deleveraging might accelerate. settlement exposures. Default by as early as September In response to these developments, central banks in 23 was perceived as a very real possibility for LTCM in major advanced economies cut official interest rates. In the absence of an injection of capital. the United States, an initial cut on September 29 failed to In response to these developments and the rapid significantly calm markets; spreads continued to widen, deleveraging, market volatility increased sharply, and equity markets fell further, and volatility continued to in- there were some significant departures from normal crease. Against this background, the Federal Reserve fol- pricing relationships among different asset classes. In the lowed up on October 15 with a cut in both the federal U.S. treasury market, for example, the spread between funds target and the discount rate, a key policy action the yields of "on-the-run" and "off-the-run" treasuries that stemmed and ultimately helped reverse the deterio- widened from less than 10 basis points to about 15 basis rating trend in market sentiment. The easing—coming so points in the wake of the Russian debt restructuring, and soon after the first rate cut and outside a regular FOMC to a peak of over 35 basis points in mid-October, sug- meeting (the first such move since April 1994)—sent a gesting that investors were placing an unusually large clear signal that the U.S. monetary authorities were pre- premium on the liquidity of the "on-the-run" issue. pared to move aggressively if needed to ensure the nor- Spreads between yields in the eurodollar market and on mal functioning of financial markets. U.S. treasury bills for similar maturities also widened to Calm began to return to money and credit markets in historically high levels, as did spreads between commer- mid-October. Money market spreads declined quickly to ical paper and treasury bills and those between the fixed precrisis levels, while credit spreads declined more leg of fixed-for-floating interest rate swaps and govern- slowly and remained somewhat above precrisis levels, ment bond yields, pointing to heightened concerns about probably reflecting the deleveraging. The Federal Re- counterparty risk. Interest rate swap spreads widened in serve cut both the federal funds target and the discount currencies including the U.S. dollar, deutsche mark, and rate at the FOMC meeting on November 17, noting that pound sterling. In the U.K. money markets, the spread of although financial market conditions had settled down sterling interbank rates over general collateral repo rates materially since mid-October, unusual strains remained. rose sharply during the fourth quarter, partly owing to Short-term spreads subsequently declined. The calming concerns about liquidity and counterparty risk (and also effect of the rate cuts suggested that the turbulence reflecting a desire for end-of-year liquidity). stemmed primarily from a sudden and sharp increase in As securities prices fell, market participants with pressures on (broadly defined) liquidity, including securi- leveraged securities positions sold those and other se- ties market liquidity, triggered by a reassessment of risk. tivities rise to levels that create hypersensitivity to and putting on hedges, while debtors draw down sudden unanticipated changes in market conditions capital and liquidate other assets. Until OTC deriv- (such as interest rate spreads) and new information. atives exposures contract to a sustainable level, The creditor and debtor relationships implicit in markets can remain distressed and give rise to sys- OTC derivatives transactions between the interna- temic problems. This is what happened in 1998: tionally active financial institutions can create situ- after it became known that LTCM might default, ations in which the possibility of isolated defaults some dealers were concerned that their dealer can threaten the access to liquidity of key market counterparties were heavily exposed to LTCM. The participants—similar to a traditional bank run. This induced changes in market conditions quickly cre- can significantly alter perceptions of market condi- ated a run for liquidity. tions, and particularly perceptions of the riskiness Greater asset price volatility related to the rebal- and potential size of OTC derivatives credit expo- ancing of portfolios may be a reasonable price to pay sures. The rapid unwinding of positions, as all for the efficiency gains from global finance. How- counterparties run for liquidity, is characterized by ever, in the 1990s, OTC derivatives activities have creditors demanding payment, selling collateral, sometimes exhibited an unusual volatility and have

7 II MODERN BANKING AND OTC DERIVATIVES MARKETS

added to the historical experience of what volatility the world's top derivatives traders and risk managers can mean. For example, in the 1990s, there were re- from three major derivatives houses could not deter- peated periods of volatility and stress in different mine how to unwind LTCM's derivatives books asset markets (ERM crises; bond market turbulence rapidly in an orderly fashion without retaining LTCM in 1994 and 1996; Mexican, Asian, and Russian staff to assist in liquidating the large and complex crises; LTCM; Brazil) as market participants portfolio of positions. searched for higher rates of return in the world's Both private market participants and those respon- major bond, equity, foreign exchange, and deriva- sible for banking supervision and official market tives markets. Some of these episodes suggest that surveillance are learning to adapt to the fast pace of the structure of market dynamics has been adversely innovation and structural change. This challenging affected by financial innovations and become more learning process has been made more difficult be- unpredictable, if not unstable. cause OTC derivatives activities may have changed Examples of extreme market volatility include the nature of systemic risk in ways that are not yet movements in the yen-dollar rate in both 1995 and fully understood.5 The heavy reliance on OTC deriv- 1998. In both cases the yen-dollar exchange rate ex- atives appears to have created the possibility of sys- hibited what might be characterized as extreme price temic financial events that fall outside of the more dynamics—beyond what changes in fundamentals formal clearinghouse structures and official real- would suggest was appropriate—in what was, and time gross-payment settlement systems that are de- is, one of the deepest and most liquid markets. The signed to contain and prevent such problems. There extreme nature of the price dynamics resulted in part is the concern that heavy reliance on new and even from hedging positions involving the use of OTC more innovative financial techniques, and the possi- derivatives contracts called knockout options (see bility that they may create volatile and extreme dy- Box 2.2: The Role of OTC Currency Options in the namics, could yet produce even greater turbulence Dollar-Yen Market, page 5). These OTC options are with consequences for real economic activity—per- designed to insure against relatively small changes haps with consequences reaching the proportions of in an underlying asset price. Yet once a certain real economic losses typically associated with finan- threshold level of the yen-dollar rate was reached, cial panics and banking crises. the bunching of these OTC options drove the yen- In sum, the internationally active financial institu- dollar rate to extraordinary levels in a very short pe- tions have increasingly nurtured the ability to profit riod of time—an event that the OTC options were from OTC derivatives activities and financial market not designed to insure against. participants benefit significantly from them. As a re- Such episodes of rapid and severe dynamics can sult, OTC derivatives activities play a central and also pose risks to systemic stability. In particular, the predominantly a beneficial role in modern finance. turbulence surrounding the near-collapse of LTCM in Nevertheless, the important role of OTC derivatives the autumn of 1998 posed the risk of systemic conse- in modern finance, and in particular in recent periods quences for the international financial system, and of turbulence, raises the concern that the instabilities seemed to have created consequences for real eco- associated with modern finance and OTC deriva- nomic activity (see Box 2.3: LTCM and Turbulence tives markets could give rise to systemic problems in Global Financial Markets, page 6). This risk was that potentially could affect the international finan- real enough that major central banks reduced interest cial system. rates to restore risk taking to a level supportive of more normal levels of financial intermediation and continued economic growth. LTCM's trading books were so complicated and its positions so large that 5See Greenspan (1998) and Tietmeyer (1999).

8