The response of several emerging market authorities, among other factors, suggests that the use of over-the-counter instruments (in particular, derivatives) and off-balance-sheet items, while in itself unlikely to have triggered market disruption, may have contributed to the severity and dynamics of the current financial crisis. For example, financial authorities in certain Eastern European and East Asian jurisdictions are reported to have taken or have considered taking measures against a form of OTC currency derivative known as non-deliverable forwards (NDFs) that are said to have played a role in heightened volatility of domestic currencies and securities. Moreover, it has been suggested that the use of such products exacerbated both the European exchange-rate mechanism crisis of 1992-93 and the Mexican peso crisis of 1995-96, and that their use may have had a similar effect on the recent crisis in Asia.

Survey responses have suggested that OTC products may have played a significant role in the massive build-up of private short-term foreign debt in several emerging-market jurisdictions. One survey respondent acknowledged that, with the crisis, financial institutions under its jurisdiction were exposed to greater risks from their off-balance-sheet transactions. Moreover, in at least one other jurisdiction, OTC instruments were responsible for an accumulation of official short-term foreign debt. It was reported that in this jurisdiction, the central bank had eventually built up significant short-term foreign obligations which had arisen from forward contract positions taken in defending the currency during the crisis.

While some have argued that much OTC and off-balance-sheet activity is, in fact, prudent and proper, others have raised specific concerns relating largely to the difficulty in monitoring such activity-compared to that which takes place on-exchange for example. These concerns tend to stem from the relative ease with which such instruments can provide leverage, and hence amplify risks; their ability to facilitate complex speculative positions; and the fact that they are, by and large, opaque to accounting recognition, measurement and disclosure.

First, there is some concern that their use can exacerbate short-run price volatility. A recent report by the Basle Euro-currency Standing Committee identifies several ways in which this may occur. The continuous revision of hedge positions ("dynamic hedging") of short options exposures, which requires the purchase of underlying assets when markets rise and their sale when markets fall, can accentuate an initial price-shock through positive feedback effects. Related to this, so-called "hedging overhangs", in which hedging transactions are undertaken by many market participants simultaneously, may trigger large price movements. Volatility may also beget volatility: in times of heightened price fluctuations, margin and collateral calls on derivative-based positions may force the liquidation of both derivative and underlying positions; moreover, the strict assumptions underlying derivatives pricing and trading can become invalid during times of severe market stress, and this can lead to a reduction in market liquidity and can generate valuation uncertainties.

Second, there is some concern that certain OTC instruments facilitate excessive risk-taking by market participants. While there is some debate as to whether they encourage market participants to assume too much risk, it is generally accepted that such instruments make it relatively easy for users should they wish to do so. This is because, by affording leverage and low transaction costs, they facilitate the taking of speculative positions. Thus, they amplify the risks associated with holding them for the potential of much higher rewards. Moreover, it has been argued that if designed in particular ways, such instruments might also enable market participants to circumvent prudential regulations or controls, and thus allow them to assume more risk than they otherwise could have.

A third area of concern that has also been identified is that OTC instruments, through particular features such as complex pay-off structures and cross-border components, can be opaque to on-balance-sheet accounting techniques. It is argued that this makes it easier for market participants to circumvent (or at least only partially comply with) domestic capital controls, reporting requirements and prudential regulations, thus effectively hiding the financial system's true exposure to market and liquidity risk from authorities. It has also been suggested that the use of such off-balance-sheet products has complicated the distinction between traditional measures of long- and short-term foreign debt exposure, as well as of direct and portfolio investment from abroad. ^46,47