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Over-the-Counter Derivatives and Systemic Risk to the Global Financial System

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  • Michael R. Darby

Abstract

Over the last decade dealing in derivative financial instruments (basically forwards, futures, options and combinations of these), particularly in the over-the-counter (OTC) derivatives market has become a central activity for major wholesale banks and financial institutions. Measured in terms of notional principal amount, OTC derivatives outstanding are near, if not greater than, US$10 trillion, even after deduction of double-counting for intra-dealer transactions. Major new regulatory initiatives, including proposed new capital requirements, are under consideration as a means of reducing systemic risk. This paper examines the concept of systemic risk -- that failure of one firm will lead to the failure of a large number of other firms or indeed the collapse of the international financial system. Alternative proposed definitions are considered and integrated and the effects of OTC derivatives on these risks discussed. The key conclusion is that systemic risk has been reduced by the development of the OTC derivatives market due to shifting economic risks to those better able either to bear the risk or, in many cases, cancel it against offsetting risks. The implications of the Basle II capital proposals for systemic risk are analyzed and shown to increase this risk due to encouraging transactions which increase portfolio risks of the dealers and discouraging transactions which decrease their portfolio risk.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4801.

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Date of creation: Jul 1994
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Publication status: published as Darby, Michael R. "Over-The-Counter Derivatives And Systematic Risk To The Global Financial System," Advances in International Banking and Finance, 1997, v3(1), 215-235.
Handle: RePEc:nbr:nberwo:4801

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  1. Litzenberger, Robert H, 1992. " Swaps: Plain and Fanciful," Journal of Finance, American Finance Association, vol. 47(3), pages 831-50, July.
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Cited by:
  1. von Hagen, Jürgen & Fender, Ingo, 1998. "Central bank policy in a more perfect financial system," ZEI Working Papers B 03-1998, ZEI - Center for European Integration Studies, University of Bonn.
  2. de Bandt, Olivier & Hartmann, Philipp, 2000. "Systemic Risk: A Survey," CEPR Discussion Papers 2634, C.E.P.R. Discussion Papers.
  3. Robert C. Merton, 1995. "Financial Innovation and the Management and Regulation of Financial Institutions," NBER Working Papers 5096, National Bureau of Economic Research, Inc.
  4. Bartram, Sohnke M. & Brown, Gregory W. & Hund, John E., 2007. "Estimating systemic risk in the international financial system," Journal of Financial Economics, Elsevier, vol. 86(3), pages 835-869, December.
  5. Michael D. Bordo & Bruce Mizrach & Anna J. Schwartz, 1995. "Real Versus Pseudo-International Systemic Risk: Some Lessons from History," NBER Working Papers 5371, National Bureau of Economic Research, Inc.
  6. Sheri M. Markose, 2012. "Systemic Risk from Global Financial Derivatives," IMF Working Papers 12/282, International Monetary Fund.
  7. Chiara Oldani, 2005. "An Overview of the Literature about Derivatives," Macroeconomics 0504004, EconWPA.

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