The often exotic hedging strategies used in over-the-counter (OTC) derivatives swaps contracts are back in favor with portfolio managers.

That’s the view of several fund managers, some of whom question whether they were ever out of favor despite the market meltdown of 2008. Contrary to conventional wisdom, OTC derivative contracts remain an important part of their hedging and liquidity strategies.

Asked about OTC derivatives in the post-Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 environment, managers said that, even before the new law, they believed these contracts were and would remain important tools in running portfolios.

“We still use them as we have used them because for the most part these instruments really serve a purpose for risk management,” according to Daniel Shackelford, manager of T. Rowe Price’s New Income Fund. “We don’t want to lose sight of the fact that we can best serve our clients by using derivatives in some cases in the cash market,” Shackelford adds.

Managers also point to several factors promoting their use of OTC derivatives in a safer, more transparent environment than the previous use of private trades, only backed by the resources of the two dealers involved. Regulatory changes forced more transparency in the trading of these contracts. These required the use of a CCP, a central clearing party clearinghouse.

The clearinghouse requires that parties post enough in margin to protect both parties against a failed trade. The clearinghouse is responsible for ensuring these margin amounts are up to date as the value of the contracts change.

Most of the OTC contracts are being cleared and most of them are being better collateralized, “which actually puts us in a better position,” Shackelford says. “That part of Dodd-Frank I think was good. There’s more price transparency in these contracts, which is beneficial for us.”

Dodd-Frank, another manager says, changed the OTC derivatives landscape. “Overall, yes, the standardization and electronic clearing of certain derivatives should help. More transparency, theoretically, makes for better markets,” says Peter Marber, head of emerging markets investments for Loomis, Sayles & Co.

That, apparently, is making some OTC derivatives players feel less queasy about these products, two of the most popular of which are credit default and interest rate swaps. Managers and others are buying more of them. The notional value of OTC contracts is up some $60 trillion, to $710 trillion, from three years ago, according to the Bank for International Settlements (BIS).

“You’re making a manager adhere to a margin level. There’s the perception of safety,” says Jeffrey Sherman, co-portfolio manager of the DoubleLine Shiller Enhanced CAPE Fund. “These contracts are certainly not riskier now. How much safer they are is debatable; it is all about how people use these contracts.”

“We’ve used both electronic and OTC contracts in the past, and we’re hoping this new trend could help provide more easy-to-use tools to help manage our portfolios,” says Marber. “They certainly should help with more transparent pricing.”

Robert Persons, who runs the MFS Bond Fund, which generally has not used OTC derivatives because he has other ways to access liquidity, agreed that the contracts are viewed as less dangerous. “I don’t see any warning signs that leads us to believe that the use of these contracts is risky,” he says. “In fact, I think these contracts are probably used to reduce risk.”

Managers also told Financial Advisor that there is another factor in why players perceive these contracts as less dangerous: More managers are using them. The recent BIS derivative numbers over the last year and a half show the healthy growth of these instruments.

“OTC derivatives markets continued to expand in the second half of 2013,” said a BIS release. “The notional amount of outstanding contracts totaled $710 trillion at the end of 2013. Up from $693 trillion at the end-June 2013 and $633 trillion at the end of 2013.” (See table).

For the first half of this year, the number of OTC contracts had increased, but the notional value had declined. “This drop,” say BIS officials “is explained by a dealer’s reclassification of contracts with central counterparties.”

OTC derivatives, which some like Warren Buffett called financial weapons of mass destruction, were blamed by many for the market meltdown of 2008. That’s because many dealers were executing contracts privately—using a bilateral (or dealer-to-dealer model) and pricing them privately.

Critics said those using these much-in-demand OTC contracts—offering everything from interest rate swaps to involved hedging strategies to protect some companies from the sudden rise in the price of a precious commodity such as oil—confused market participants in the 2008 market meltdown. Worse than that, certain contracts like credit default swaps threatened to bring down several big brokerages that had built up huge inventories of them. That triggered a moral hazard problem. Almost every big brokerage that ran into problems claimed it had to be bailed out or the entire system would fail. (See Sidebar: “How Did They Work? How Do They Work Now?”)

Using these OTC contracts, they often became unsure what the value of the contracts was. Even parties that were financially sound and could pay their contracts were worried: What if the counterparty wasn’t so solid? It could fail and drag it down with it. The market became locked.

Dodd-Frank, with a few exceptions, now requires most of these contracts to go through a clearing process in a public environment. Clearing is seen by many as a way to reduce counterparty risk as two parties have to produce assets to ensure that a trade can be completed. Most OTC transactions have to be completed, Dodd-Frank stipulates, in a CCP/clearinghouse. Some swaps can’t and probably never will be because there is not enough volume.

Those thinly traded contracts—the so-called custom derivatives contracts—are unlikely to ever go through a clearing process and will likely continue to use the bilateral, dealer-to-dealer method. However, under Dodd-Frank, parties to the trade will require huge amounts of collateral to ensure against counterparty failure.

DoubleLine’s Sherman says the firm’s policy is to use these contracts only if they “provide an inherent advantage to the client. But we will never allow our funds to grow so large that we expose them to counterparty default risk embedded in swaps just so we can get more fee income off a bloated assets under management.”

Are players who use these contracts now less exposed to the risks of 2008? Could a market meltdown, triggered or caused in part by OTC derivatives, happen again? Sherman says he thinks Dodd-Frank’s protections are helpful but there is no guarantee that they will prevent another financial crisis.

How could it happen? Even the lawmakers who designed a solution concede the solution could fail.

“Large financial institutions would own and control the clearinghouses and effectively set rules for their own derivatives deals,” according to the wording of Dodd-Frank. The lawmakers called on the clearinghouses to “reduce systemic risk,” but managers say Dodd-Frank has only reduced risk, not eliminated it.

Indeed, one bond manager who uses OTC derivative contracts as a hedging device privately warned “that the rise of those using these CCPs, here and in Europe, could lead to a different kind of risk, the risk of one of them [a clearing house] failing. This is something that all market participants must heed.”

He cautions that with competition, each CCP could operate differently. One could set margin requirements lower to attract more business, and that might mean some CCPs are less careful than others. “It is very important,” the manager said, “for market participants to carefully select, and subsequently monitor, each CCP.”

And what happens, Sherman asks, in the next financial crisis, when a CCP or a clearinghouse fails?

“If we had another day like the crash of 1987, the movement that day could wipe people out and then the clearinghouse has a problem,” says Sherman, though he thinks Dodd-Frank has added some protection.

Dodd-Frank “was built with some guardrails on it,” he says. “But if you’re driving your Ferrari too fast down a twisty road, you can still go through the guardrails.”