However, interest rate derivatives have experienced stronger growth given the sensitivity to interest rate changes and the need to manage exposure to fixed and floating rate financial assets. BIS Review 11/2004  1  In the international financial markets, the growth in OTC derivatives has been phenomenal in recent years. The statistics compiled by the Bank for International Settlements indicate that as of the end of June 2003 the total outstanding OTC derivatives in notional amounts was 169 trillion US dollars. This total figure includes 22 trillion US dollars of foreign exchange contracts, 121 trillion US dollars of interest rate contracts, principally swaps, 2.7 trillion US dollars of equity-linked contracts, almost 1 trillion US dollars of commodity contracts and 18 trillion US dollars classified as Others. The fact that growth in financial derivatives has far surpassed the growth in the underlying real economies that generated the original transactions and risks for diversification is a matter of concern to regulators. It seems that speculators appear to have embraced derivatives as another form of investment for short-term capital gains. If financial derivatives take on a life of their own due to excessive speculative activity, the utility for risk diversification may prove illusory from a systemic point of view because the new risks introduced by derivatives may well overshadow the risks posed to the financial system by the underlying more risky financial assets.

The process of financial intermediation responds to changes in the environment with product and service innovations, and in this manner have continually re-shaped the international financial landscape. Derivatives are among the most innovative sub-sectors of the financial industry. Specifically, the ‘over-the-counter’ (OTC) products are not derivatives on organized markets, but rather individually customized, often highly complex with combinations of standard financial instruments packaged together to meet the specific needs of clients. Such contracts involve very little direct lending by banks to clients, and generate little net interest income to the banks. Derivatives generate substantial fee and commission income without the need to commit any of the institution’s capital. This therefore involves a different risk management approach as there is a shift away from continuous risk assessment and risk monitoring of funded investment projects that usually produce recurring flows of interest payments over time to the identification of riskless ‘trades’ that produce large, single payments, with much of the residual risks carried by purchasers of such packages. This process has possibly been accelerated by the introduction of risk-weighted capital requirements. Market players and regulators both have a role to play in balancing potential risk with potential returns in order to promote a vibrant financial system, without compromising the stability and integrity or agility of the system. One of the Central Bank’s primary responsibilities is to maintain financial stability and confidence in the financial system and to ensure that the process of financial intermediation continues to function without disruptions.