What we know about the global financial crisis is that we don’t know very much.
Paul Samuelson (1915–2009)
In 2007, a US housing crisis led to a credit crisis, which caused the failures of large financial institutions and a severe economic downturn. The aftermath of the ‘global financial crisis’ (GFC) is still being felt across the general economy, and has led to significant changes in the functioning of financial markets and the way in which financial institutions are regulated. The GFC highlighted the importance of controlling risk in over-the-counter (OTC) derivatives to maintain global financial stability. Whilst OTC derivatives did not cause the GFC, they likely contributed to amplifying various problems and provided channels for systemic risk to propagate.
A derivative trade is a contractual relationship that may be in force from a few days to several decades. During the lifetime of the contract, the two counterparties have claims against each other such as in the form of cashflows that evolve as a function of underlying assets and market conditions. Derivatives transactions create counterparty credit risk (counterparty risk) due to the risk of insolvency of one party. This counterparty risk in turn creates systemic risk due to derivatives trading volume being dominated by a relatively small number of large derivatives counterparties (‘dealers’) that are then key nodes of the financial system. Counterparty risk refers to the possibility ...