18

Regulating OTC Derivatives*

Viral V. Acharya Or Shachar Marti Subrahmanyam†

18.1 OVERVIEW

Over-the-counter (OTC) derivatives account for a significant proportion of overall banking and intermediation activity. On the one hand, they enable end users like corporations, including industrial and financial firms, to hedge their underlying risk exposures in a customized manner. For example, an airline may hedge the price of its future commitments to buy jet fuel or a mutual fund may reduce its portfolio's exposure to exchange rate movements using such products. On the other hand, they enable banks and other financial intermediaries – the providers of hedging services to end users – to earn profits, as they in turn hedge the customized OTC products they sell, either by diversifying the risk across different end users or by shedding the risk to other intermediaries via liquid markets for standardized derivatives. The profit earned by the intermediaries is, in part, a compensation for the mismatch between the risks of the standardized and the customized products. It is clear that there is value to the economy from trading in derivatives, which enables users to hedge and transfer risk by altering the patterns of their cash flows. Interest rate swaps, for example, are the largest segment of OTC derivative markets and have contributed remarkably to the management of interest rate risk on corporate and commercial bank balance sheets. It is not surprising, therefore, that the use of derivatives ...

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