Dialogic regulation for OTC derivatives in Dodd-Frank: a suggested legal principle

Abstract

The purpose of this paper is to consider whether the regulatory measures on over the counter (OTC) derivatives under Article VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 (Dodd-Frank), introduced in the United States of America are able to address the problems posed by the said OTC derivatives instruments. The financial instruments engineered by OTC derivatives prior to the financial crisis of 2008 were and are still widely deployed for the purported purpose of hedging against risk. Examples of such risks are: fluctuation in currency rates or commodity prices or default risk in loans payment. However, such financial instruments are also employed for speculation on the fluctuation of the currency rates or the commodity prices or any other indices in the financial market. Its purpose is for higher financial yield. It is this latter aspect of the trade that OTC derivatives are more popular than exchange traded (ET) derivatives because the former is not subjected to regulatory control. They are therefore more flexible and tailored to the needs of the customers. And the costs of entering into OTC derivatives are less than ET derivatives because the latter are subjected to administrative and margins costs imposed by the exchanges. The popularity of the OTC derivatives market with the investors and speculators coupled with increasing new financial products - embedded with OTC derivatives elements, resulted in OTC derivatives to be traded at a phenomenally high level at the time of the crisis. According to Bruce Carruthers, in the United States, in 1986 the total value of ET derivatives was more than OTC derivatives. By 2008 the total value of OTC derivatives had become ten times greater than the ET derivatives even though the latter had increased by one hundred fold. Lynn Stout provided the numbers in the growth of OTC derivatives as follows: according to the Bank for International Settlements, at the end of 1999 the total notional value of OTC derivatives was approximately US$88 trillion. By 2008 the OTC market value had a value of about US$600 trillion. Major financial institutions and banks held a disproportionate amount of such instruments and their value could not be determined. They became a liability as opposed to instruments which provide insurance to risk. These factors which relate to the excesses of the trade, amongst others, brought about a systematic risk to the financial market.