OTC versus Exchange traded products

Q: How the OTC market precipitated the whole financial crises?

A: OTC market is generally non-transparent, highly leveraged and provides higher profit margins to financial intermediaries than exchange traded products. And in some cases the contracts are not marked to market and no collateral is posted with the custodian. Commonly traded contracts on OTC market are currency and interest rate swaps and CDS. Thus, OTC traders are exposed to each other's credit risk. But the nominal value of outstanding OTC derivatives contracts at the end of 2008 stood at $592 tn, 10 times more than nominal value of $57.6 tn for ET contracts. When housing market sank and with it the mortgage backed securities, AIG took a hit as the seller of CDS written on MBS. And a CDS is an OTC contract.

Q: What is a Credit Default Swap?

A: A CDS is a derivative contract bought by lenders as an insurance against a possible default of credit by the borrowers. The FI writing the CDS agrees to buy the bonds at their face value ( principal amount) in the case the borrower defaults on its payment. The total face value of the bonds of which CDS is written is known as notional principal of that CDS. During late 90s and early 2000s, banks made extensive use of CDS to transfer credit risk to other parts of financial system.