Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest.
As the word suggests, derivatives that trade on an exchange are called exchange traded derivatives, whereas privately negotiated derivative contracts are called OTC., contracts.
The OTC.. derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernization of commercial and investment ban king and globalization of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC., derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC., derivative positions were the main cause of turbulence in financial markets in 1998. These episodes have turbulence revealed the risks posed to market stability originating in features of OTC., derivative instruments and markets. The OTC., derivatives markets have the following
The Management of counter-party (Credit) risk is located and decentralized within individual Institutions.
There are no formal centralized limits on individual positions leverage or marginalizing.
There are no formal rules for risk and burden-sharing.
There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants.
The OTC.. contracts are generally not regulated by a regulatory authority and the exchange’s self regulatory organisation although they are affected indirectly by national legal systems, banking supervision and market surveillance.
Some of the features of OTC., derivatives markets embody risks to financial market stability. The following features of OTC., derivative market can give rise to instability in institutions, markets, and the international financial system. 1. The dynamic nature of gross credit exposures. 2. Information asymmetries, 3. The effects of OTC.. derivative activities on available aggregate credit, 4. The high concentration of OTC., derivative activities in major institutions and 5. The central role of OTC., derivatives markets in the global financial system. Instability arises when shocks, such as counter party credit events and sharp movements in asset prices that underlie derivative contracts occur, which significantly alter the perceptions of current and potential future credit exposures. When asset prices change rapidly, the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwinding of positions.
There has been some progress in addressing these risks and perceptions. However, the progress has been limited in implementing reforms in risk management, including counterparty, liquidity and operational risks, and OTC., derivatives markets continue to pose a threat to international financial stabgility. The problem is more acute as heavy reliance on OTC., derivatives creates the possibility of systemic financial events, which fall outside the more formal clearing house structures. Moreover, those who provide OTC.. derivative products, hedge their risks through the use of exchange traded derivatives. In view of the inherent risks associated with OTC.. derivatives, and their dependence on exchange traded derivatives. Indian Law considers them illegal.