Non-dealer Clearing of Over-the-counter Derivatives

Much of the underlying demand for OTC derivatives originates from non-dealer financial institutions, such as institutional investors, or non-financial corporations (collectively referred to as ‘non-dealers’ in this article). Often, such firms use OTC derivatives to hedge financial risks arising from their investments or real economic activities. A life insurance provider, for instance, may use OTC interest rate derivatives to better match the interest rate exposure of its assets and liabilities. In some cases, a firm may also use derivatives to gain a ‘synthetic’ exposure to a particular risk without transacting directly in the underlying asset, perhaps as a temporary measure to smooth investment flows. For example, a fund manager that has received an inflow of investment funds may initially use credit derivatives as an efficient and timely means of gaining a desired exposure before gradually building a position in the underlying securities. Non-dealer activity is generally intermediated by dealers, typically large financial institutions. These firms then execute offsetting transactions with other dealers to maintain a broadly balanced overall position.1