The Development of Financial Derivatives Markets: The Canadian Experience

In response to an intense demand for risk management services since the early 1980s, the over-the-counter (OTC) markets for financial derivatives in Canada have developed more vigorously than those for exchange-traded (EXT) derivative securities. This is particularly evident for interest rate derivatives. The objectives of this paper are to examine why Canadian interest rate derivatives have developed more robustly in OTC markets than in EXT markets and why markets for some EXT derivatives have developed more successfully than for others.

The paper concentrates on the basic derivatives—options, futures or forwards, and swaps. The investigation suggests that many of the informational and strategic financial requirements of Canadian institutional borrowers and lenders are served better in the markets for OTC financial derivatives than in the EXT derivatives markets. Furthermore, a high degree of integration with securities markets in the United States, combined with illiquidity in domestic securities markets, places many Canadian EXT derivatives at a competitive disadvantage in North American securities markets. Two other factors have also contributed to the stronger growth of markets for OTC interest rate derivatives in the Canadian financial system: the dominant position of chartered banks, which are the primary suppliers of domestic OTC interest rate derivatives, and the presence of regulatory barriers to the development of markets for financial derivatives, particularly EXT derivatives.

This paper concludes that the robust development of markets for OTC derivatives relative to those for EXT derivatives is not necessarily a regrettable outcome since both types of derivatives perform the same basic function. However, the paper warns that unwarranted regulatory barriers to the development of particular financial derivatives markets can have permanent economic effects.