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 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

unregulated and largely opaque, with no public reporting requirements and little or
no price discovery. With the Lehman bankruptcy, participants in the market became
concerned about the exposures and creditworthiness of their counterparties and the
value of their contracts. That uncertainly caused an abrupt retreat from the market.
Badly hit was the market for derivatives based on nonprime mortgages. Firms had
come to rely on the prices of derivatives contracts reflected in the ABX indices to
value their nonprime mortgage assets. The ABX.HE.BBB- -, whose decline in
 had been an early bellwether for the market crisis, had been trading around 
cents on the dollar since May. But trading on this index had become so thin, falling
from an average of about  transactions per week from January  to September
 to fewer than  transactions per week in October , that index values

weren’t informative. So, what was a valid price for these assets? Price discovery was
a guessing game, even more than it had been under normal market conditions.
The contraction of the OTC derivatives market had implications beyond the valu-
ation of mortgage securities. Derivatives had been used to manage all manner of
risk—the risk that currency exchange rates would fluctuate, the risk that interest rates
would change, the risk that asset prices would move. Efficiently managing these risks
in derivatives markets required liquidity so that positions could be adjusted daily and
at little cost. But in the fall of , everyone wanted to reduce exposure to everyone
else. There was a rush for the exits as participants worked to get out of existing trades.
And because everyone was worried about the risk inherent in the next trade, there
often was no next trade—and volume fell further. The result was a vicious circle of
justifiable caution and inaction.
Meanwhile, in the absence of a liquid derivatives market and efficient price dis-
covery, every firm’s risk management became more expensive and difficult. The usual
hedging mechanisms were impaired. An investor that wanted to trade at a loss to get
out of a losing position might not find a buyer, and those that needed hedges would
find them more expensive or unavailable.
Several measures revealed the lack of liquidity in derivatives markets. First, the
number of outstanding contracts in a broad range of OTC derivatives sharply de-
clined. Since its deregulation by federal statute in December , this market had
increased more than sevenfold. From June ,  to the end of the year, however,
outstanding notional amounts of OTC derivatives fell by more than . This de-
cline defied historical precedent. It was the first significant contraction in the market
over a six-month period since the Bank for International Settlements began keeping

statistics in . Moreover, it occurred during a period of great volatility in the fi-
nancial markets. At such a time, firms usually turn to the derivatives market to hedge
their increased risks—but now they fled the market.
The lack of liquidity in derivatives markets was also signaled by the higher prices
charged by OTC derivatives dealers to enter into contracts. Dealers bear additional
risks when markets are illiquid, and they pass the cost of those risks on to market
participants. The cost is evident in the increased “bid-ask spread”—the difference be-
tween the price at which dealers were willing to buy contracts (the bid price) and the
price at which they were willing to sell them (the ask price). As markets became less