Deconstructing Over-the-Counter Derivatives

Tuesday, January 1st, 2002 at 12:00 am by Norman Menachem Feder
Norman Menachem Feder, Deconstructing Over-the-Counter Derivatives, 2002 Colum. Bus. L. Rev. 677

Derivatives transactions drive companies today to efficiencies and sophistication unimaginable only two or three decades ago. Not only that, they appeal; derivatives nowadays trade globally and massively. The popularity of derivatives is especially noticeable in the over-the-counter, or off-exchange, markets.

The over-the-counter–better known as OTC–derivatives markets are non-centralized markets that comprise myriad privately negotiated transactions. These markets function in and across many jurisdictions and currencies, engender trillions of notional transaction dollars a year and, in many measures, dwarf exchange-traded derivatives markets. There is also good reason to expect that the OTC derivatives markets will expand further, not least because new participants appear regularly. Typically, an awakening to the various opportunities offered by OTC derivatives or an easing of regulatory barriers induces the new arrivals.

Despite the seeming ubiquity of OTC derivatives, practitioners often find that the products suffer from an unfortunate aspect: complexity. It is this author’s observation, for example, that the structure and documentation of OTC derivatives initially mystify many managers who desire the opportunities offered by OTC derivatives, but are new to the seemingly esoteric methods of these transactions. That others whom this author has not observed are similarly stymied can only be presumed. All this is understandable and casts no aspersions on the capabilities of frustrated managers because, at first and even second glance, the architecture of OTC derivatives transactions is dense. The perceived opacity of OTC derivatives transactions is regrettable because it at best slows and at worst preempts full scale and intelligent adoption of OTC derivatives. With some guidance, however, the efficacy and elegance of today’s OTC derivatives and their market-standard documents can be revealed to all.

In the Discussion that follows, this article seeks to provide that guidance. Part A describes the basic reasons for, and important features of, all OTC derivatives transactions. Part B profiles the various forms of derivatives transactions, using relatively common market risk derivatives as examples. Part C explores a prominent and comparatively new form of OTC derivatives products called credit derivatives. Part D addresses whom exactly engages in derivatives transactions and why. Part E discusses certain risks that OTC derivatives themselves generate. Part F explains the differences between on-exchange and OTC derivatives transactions. Part G reviews the campaign to standardize the documentation of OTC derivatives transactions. Part H examines the makeup of the standard documentation that currently prevails in the OTC market.

Author Information

Member of the law firm of Caspi & Co.