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Asked about OTC derivatives in the post-Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 environment, managers said that, even before the new law, they believed these contracts were and would remain important tools in running portfolios. “We still use them as we have used them because for the most part these instruments really serve a purpose for risk management,” according to Daniel Shackelford, manager of T. Rowe Price’s New Income Fund. “We don’t want to lose sight of the fact that we can best serve our clients by using derivatives in some cases in the cash market,” Shackelford adds.
Managers also point to several factors promoting their use of OTC derivatives in a safer, more transparent environment than the previous use of private trades, only backed by the resources of the two dealers involved. Regulatory changes forced more transparency in the trading of these contracts. These required the use of a CCP, a central clearing party clearinghouse. Most of the OTC contracts are being cleared and most of them are being better collateralized, “which actually puts us in a better position,” Shackelford says. “That part of Dodd-Frank I think was good. There’s more price transparency in these contracts, which is beneficial for us.”
Managers also said that there is another factor in why players perceive these contracts as less dangerous: More managers are using them. The recent BIS derivative numbers over the last year and a half show the healthy growth of these instruments. “OTC derivatives markets continued to expand in the second half of 2013,” said a BIS release. “The notional amount of outstanding contracts totaled $710 trillion at the end of 2013.
Critics said those using these much-in-demand OTC contracts - offering everything from interest rate swaps to involved hedging strategies to protect some companies from the sudden rise in the price of a precious commodity such as oil - confused market participants in the 2008 market meltdown. Worse than that, certain contracts like credit default swaps threatened to bring down several big brokerages that had built up huge inventories of them. That triggered a moral hazard problem. Almost every big brokerage that ran into problems claimed it had to be bailed out or the entire system would fail.