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Should OTC Derivatives Be Regulated?  Why or Why Not?

Student’s Name

Institution Affiliation
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Should OTC Derivatives Be Regulated?  Why or Why Not?

Derivatives are types of security whose value depends on the prices of underlying assets.

According to Desai (2011), some of the most common underlying assets include bonds, stocks,

interest rates, currencies, and commodities. Derivatives allow users to hedge against price

fluctuations in interest rates and exchanges. The derivatives are traded in two main markets,

which include over the counter derivatives and exchange-traded derivatives. In this discussion,

the focus is on the over the counter derivatives. According to Desai (2011), over the counter

derivatives are those traded between two parties without the need for an intermediary. Even so,

OTC derivatives face regulatory challenges and this has resulted in a need for regulation of OTC

derivatives. There are many reasons why OTC should be regulated and this essay outlines them

in detail.

According to de France (2013), regulation of OTC derivatives would ensure reporting of all

transaction details to trade data repositories (TRs). This would go a long way in enhancing

transparency for both the market participants and the official sector. de France (2013) further

suggests that this would help in supporting the management of systematic risk by allowing the

official sector to monitor, respond, and address the aggregate build-up of risk. It would also help

in permitting the market participants to have a better understating of price risk.

The other reason why OTC derivatives should be regulated is that it would constitute

standardization and this would also result in market transparency and liquidity. According to de

France (2013), when there is sufficient standardization, both in terms of operational processes

and contractual details, it would make it mandatory for OTC derivatives transactions to be

centrally traded and cleared on electronic trading platforms or exchanges. In essence, regulating
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OTC derivatives means mitigating systematic risks and protecting participants against market

abuse.

Regulating OTC derivatives means that it would be mandatory to clear them through the

central counterparty (CCP) clearinghouse. According to de France (2013), clearing OTC

derivatives through the CCPs helps in reducing systemic risks by enhancing counterparty risk

management. In essence, from this, one can see that this will also reduce the probability that the

default of a market participant will also adversely affect or destabilize other participants.

Lastly, the reason why OTC derivatives should be regulated is based on the fact that

electronic platforms and exchanges enhance transparency and also goes a long way in helping in

the reduction of market abuse. According to de France (2013), reducing market abuse is achieved

by the implementation of standardizing trading rules and processes. Once these processes are

brought to the open, it would be difficult for anyone to default them because they are monitored.
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References

de France, B. (2013). Financial Stability Review No. 17 – April 2013, Financial stability review,

retrieved from https://publications.banque-

france.fr/sites/default/files/medias/documents/financial-stability-review-17_2013-04.pdf

Desai, P. (2011). From financial crisis to global recovery. New York: Columbia University

Press.