- Burkhard Drees, Garry Schinasi, Charles Kramer, and R. Craig
- Published Date:
- January 2001
While derivatives or derivative-like features can be found in the earliest recorded financial contracts, until quite recently derivatives markets, to the extent they existed, were probably relatively illiquid. This Appendix chronicles the development of the preconditions necessary to support the high degree of liquidity that characterizes modern OTC derivatives markets. These include the rise of financial institutions capable of functioning as market makers, the establishment of derivatives exchanges that provide hedging vehicles and enable market makers to manage their risk, and advances in information technology and finance theory that facilitate more accurate pricing of OTC derivatives and measurement of risk. Derivatives or financial contracts with derivative-like features seem to have existed throughout recorded financial history. Such contracts specify rights or obligations to make or receive transfers depending on the value, or on outcomes affecting the value, of an underlying financial instrument or commodity. They encompass both separate derivatives contracts that can be traded on a market and financial contracts with embedded options or contingent clauses. Derivatives traded on markets differ from other marketable instruments in that their value “derives” entirely from that of an underlying financial instrument or commodity.
Derivative-like features can be found in very early financial contracts. The first recorded example dates back to the time of Hammurabi (1800 BC), ruler of ancient Babylon, and is included in Hammurabi’s code, the first formal recorded legal code. The code, which among other things regulated terms of credit, specified that in the event of a crop failure due to storm or drought, interest on that year’s land loan would be canceled.109 This example of a derivative, broadly defined, takes the form of a contingent clause embedded in and modifying a financial contract (the land loan) so as to give it derivative-like characteristics. The clause provides partial insurance against natural disasters by canceling interest payments when they occur.
Financial contracts with embedded options were likely the primary form of derivatives for much of recorded financial history. As financial markets developed, they seem to have evolved into forms resembling existing securities with embedded options. For example, beginning in sixteenth century Europe, convertible securities and preferred stock—instruments with derivative-like properties—appear to have been increasingly used.110 The main drawback of embedded options was that they could not be traded separately from the underlying instrument.
A key innovation was the creation of derivative instruments that could be traded separately from the underlying financial instrument or commodity. The earliest recorded such instruments appear to have been Venetian government bond forwards in thirteenth century Venice.111 In this early period, the exchange of financial instruments, and derivatives based on these instruments, seems to have initially taken place on an informal and bilateral basis in locations such as coffeehouses. In the sixteenth century, as financial activity increased in cities like Amsterdam and London, these bilateral contacts evolved into meetings of groups of investors, effectively establishing informal markets for the trading of financial instruments including derivatives. These markets could be regarded as early OTC markets in that they were based on networks of bilateral linkages, although they lacked key institutional features, such as market makers, that are the source of liquidity in modern OTC derivatives markets.
This market activity evidently provided the basis for the creation of exchanges in the emerging financial centers. These early “traditional” exchanges differed significantly from modern exchanges. Rules governing trading were much less restrictive and standardization of contracts was limited. Typically, a wide range of different financial instruments was traded on relatively illiquid markets. The modern distinction between exchange and over-the-counter trading was probably of limited relevance since trading tended to occur on a bilateral basis.
The first organized exchange was founded in Amsterdam in 1610.112 A wide range of contracts were traded on it, including stocks, commodities, insurance, a form of money market instrument, futures, and stock options. Also, there was a system of margin lending that could be used as a source of leverage.113 In London, an exchange existed by the end of the seventeenth century, although trading activity seemed to have remained somewhat more decentralized with substantial amounts of trading continuing to occur in other locations such as coffeehouses. For example, trading in equities apparently only became centralized on a single exchange in 1802. Derivatives trading was sharply curtailed in England following the collapse of the South Sea Bubble in the fall of 1720 as the result of legislation banning short sales, which was not repealed until 1836. In the United States, in the late eighteenth and early nineteenth century, the development of securities trading, including derivatives trading, followed the pattern of Amsterdam and London with the founding of the New York Stock Exchange in 1817.
Early derivatives seem to have predominantly been forwards, probably because they were relatively straightforward to value. Equity options were also traded. For example, trading in equity derivatives appears to have become well established in London by the late seventeenth century. Records indicate that these derivatives were used for risk management and speculation. They also show that investors were using relatively sophisticated finance concepts such as present value and discounted cash flow analysis to price them.114 For example, in 1692, John Houghton, owner of a London coffee shop where equity trading took place, published an explanation of how a put option could be used to hedge against a fall in the price of an equity. During the South Sea Bubble, compensation of South Sea Company management (and bribery of officials) consisted in part of stock options.
While these early derivatives markets resembled modern OTC derivatives markets in that trading occurred through a network of bilateral contacts, they lacked the liquidity of modern OTC derivatives markets, because markets lacked institutions that could act as market makers and provide liquidity by temporarily taking over and holding a seller’s derivative positions until a buyer could be located. Market making institutions only developed recently as financial instruments became available to enable them to hedge and manage the risk associated with this activity and when it became possible to accurately price derivatives and measure their risk. Also, since market making can involve carrying sizable positions, a financial infrastructure to provide the necessary financing needs to be in place. Only with the creation of liquid financial derivatives exchanges did adequate hedging instruments become available. The features of these exchanges were largely derived from modern commodity derivatives exchanges.
The first commodity futures exchange was the Osaka Rice Exchange in eighteenth century Japan. Commodity derivatives exchanges developed in roughly their current form in Chicago in the 1850s. Commodity derivatives exchanges were created to enable agricultural producers and wholesalers to hedge commodity price risk. They differed from the traditional financial exchanges, described above, in that only a limited number of standardized contracts were traded and the terms of contracts and exchange are specified by a relatively detailed set of rules. These features contributed to a high degree of market liquidity, enabling these markets to perform their price discovery function. In time, a regulatory structure developed to strengthen investor protection.
The trading of financial derivatives on modern exchanges—modeled on the commodity derivatives exchange—did not occur until quite recently. The first financial futures exchange was created in Chicago in 1970. In 1973, the first options exchange—trading call options on U.S. equities-opened, also in Chicago and, in 1977, the trading of put options was added. Subsequently, derivatives exchanges opened elsewhere in the United States and other countries such that, by the 1980s, options and futures on hundreds of equities and a wide range of bond. Treasury bill, and foreign exchange contracts were traded. The relatively recent extension of the commodity exchange model to financial derivatives can be partly attributed to several factors: the large number of underlying financial instruments, especially in the case of equities, limited the scope for standardization, making it more difficult to achieve sufficient liquidity; settlement on commodity exchanges was typically in the commodity rather than cash; and commodity exchanges were often located near commodity-producing regions far from the major financial centers where the underlying financial instruments were traded.115
The creation of liquid derivatives exchanges in combination with advances in finance theory and information technology provided the preconditions for the development of liquid OTC derivatives based on market makers by allowing them to effectively manage the risk associated with market making in OTC derivatives markets. Advances in finance theory, notably the Black-Scholes options pricing model, made it possible for the first time to accurately price many types of derivatives. They also facilitated dynamic hedging of derivatives exposures in the markets for the underlying instruments, which was useful in cases where exchange-traded derivatives were not available for hedging. The financial institutions that had been involved in derivatives activity prior to the establishment of these preconditions, either on a bilateral basis or on relatively illiquid traditional exchanges, were well positioned to function as market makers. The fact that in many cases they were large, internationally active financial institutions meant that they typically had access to the financing necessary to perform this function.
The early development of liquid OTC derivative markets was driven partly by incentives for regulatory arbitrage. These arose largely from the need to avoid capital and exchange controls that were essential elements of the post-World War II global financial system. Also, the introduction of capital requirements for banks gave rise to incentives to use OTC derivatives to circumvent or reduce them (by moving exposures off balance sheet). While regulatory arbitrage was important to the creation of these markets, market activity was increasingly driven by hedging and speculation as liquidity improved and the cost of participation fell.
The development of the foreign exchange swap market illustrates the role of regulatory arbitrage in the development of OTC derivatives markets. The first swaps were created in the 1960s to allow U.S. and U.K. multinationals who wanted to borrow in the others’ currency to circumvent U.K. exchange controls. Each firm would borrow in its own currency and then swap the principal so that no cross-border transactions were recorded (see Box 3.2: Motives for OTC Derivatives Transactions). The role of financial intermediaries was initially limited to matching counterparties (for example, they functioned as a broker). As swaps became more widely used, intermediaries took on the role of counterparty to each participant, effectively functioning as a market maker. In this capacity, they would carry the foreign currency position of a counterparty until they could find a buyer, who might be another financial intermediary. Their ability to hedge and finance such positions made it possible for them to perform this role.116
The development of an extensive and sophisticated OTC market infrastructure in the 1980s and 1990s with many of the world’s largest financial institutions serving as market makers has greatly enhanced the liquidity of OTC derivatives markets. This, in turn, has lowered the cost of participation and supported the expansion of the market. Measured by notional principal, OTC derivatives markets have grown to roughly nine limes the size of those for exchange-traded derivatives and have approximately the same turnover (see Figure 3.1).
The expansion of OTC derivatives markets will likely continue to be driven by technology and enhancements to the institutional infrastructure. The large volume of trading in some products on OTC derivatives markets has led to an increasing degree of standardization (for example, “plain vanilla” derivatives). The development of electronic trading, and clearing and settlement technologies, is making it possible to increase efficiency by introducing exchange-like trading arrangements for these products. As a result, the distinction between exchange-traded and OTC derivatives may become blurred and OTC products may increasingly compete with and displace comparable products on derivative exchanges.
The value of an asset that appears on a balance sheet based on historic cost or the original purchase price.
An intermediary between buyers and sellers who acts in a transaction as an agent, rather than a principal, charges a commission or fee, and—unlike a dealer—does not buy or sell for its own account or make markets. In some jurisdictions, the term “broker” also refers to the specific legal or regulatory status of institutions performing this function.
Provision (for example, in a master agreement) that stipulates the jurisdiction whose law governs an OTC derivatives transaction. The term sometimes is used to refer to the principles by which jurisdiction is determined in a dispute (also known as “conflict of law”).
The process of matching parties in a transaction according to the terms of a contract, and the fulfillment of obligations (for example, through the exchange of securities or funds).
An entity, typically affiliated with a futures or options exchange, that clears trades through delivery of the commodity or purchase of offsetting futures positions and serves as a central counterparty. It may also hold performance bonds posted by dealers to assure fulfillment of futures and options obligations.
Steps taken by a nondefaulting party to terminate a contract prior to its maturity when the other party fails to perform according to the contract’s terms.
Assets pledged as security to ensure payment or performance of an obligation.
The present value of the amount receivable or payable on a contract, consisting of the sum of current exposure and potential future exposure.
The exclusion of certain creditors from the automatic stay provision of the bankruptcy code, which generally limits creditors’ capacity to directly collect debts owed by a bankrupt party, including through netting of outstanding contracts. An example is the U.S. Bankruptcy Code statutory exceptions for repurchase agreements, securities contracts, commodity contracts, swap agreements, and forward contracts, where counterparties can close out exempt OTC derivatives positions outside of bankruptcy procedures.
The risk associated with the possibility that a borrower will be unwilling or unable to fulfill its contractual obligations, thereby causing the holder of the claim to suffer a loss.
An intermediary that acts as a principal in a transaction, buys (or sells) on its own account, and thus takes positions and risks. It earns profit from bid-ask spreads (and potentially from its positions). A dealer can be distinguished from a broker, who acts only as an agent for customers and charges commission. In some jurisdictions, the term “dealer” also refers to the specific legal or regulatory status of institutions performing this function.
Financial contracts whose value derives from underlying securities prices, interest rates, foreign exchange rates, market indexes, or commodity prices. Exchange-traded derivatives are standardized products traded on the floor of an organized exchange and usually require a good faith deposit, or margin, when buying or selling a contract. Over-the-counter derivatives, such as currency swaps and interest rate swaps, are privately negotiated bilateral agreements transacted off organized exchanges.
Defined by the Financial Accounting Standards Board as “the amount at which the instrument could be exchanged in a current transaction between willing participants, other than in a forced or liquidation sale.”
A contractual obligation between two parties to exchange a particular good or instrument at a set price on a future date. The buyer of the forward agrees to pay the price and take delivery of the good or instrument and is said to be “long the forward,” while the seller of the forward agrees to deliver the good or instrument at the agreed price on the agreed date, and is said to be “short the forward.” Collateral may be deposited up front, but cash is not exchanged for the good or instrument until the delivery date. Forward contracts, unlike futures, are not traded on organized exchanges.
A negotiable contract to make or take delivery of a standardized amount of a commodity or securities at a specific date for an agreed price, under terms and conditions established by a regulated futures exchange where trading takes place. It is essentially a standardized forward contract that is traded on an organized exchange and subject to the requirements defined by the exchange.
The difference between the amount advanced by a lender and the market value of collateral securing the loan. For example, if a lender makes a loan equal to 90 percent of the value of marketable securities that are provided as collateral, the difference (10 percent) is the haircut. The term also refers to formulas used in the valuation of securities for computing net capital positions of broker-dealers.
The process of offsetting an existing risk exposure by taking an opposite position in the same or a similar risk, for example, by purchasing derivatives contracts.
The process of transferring funds from an ultimate source to the ultimate user. A financial institution, such as a bank, intermediates credit when it obtains money from a depositor and relends it to a borrowing customer.
Risk that arises when a counterparty lacks the legal or regulatory authority to engage in a transaction or when the law does not perform as expected. Legal risks also include compliance and regulatory risks, which concern activities that might breach government regulations, such as market manipulation, insider trading, and suitability restrictions.
The magnification of the rate of return (positive and negative) on a position or investment beyond the rate obtained by direct investment of own funds in the cash market. It is often measured as the ratio of on- and tiff-balance-sheet exposures to capital. Leverage can be built up by borrowing (on-balance-sheet leverage, commonly measured by debt-to-equity ratios) or through the use of off-balance-sheet transactions.
The ability to raise cash easily and with minimal delay. Market liquidity is the ability to transact business in necessary volumes without unduly moving market prices. Funding liquidity is the ability of an entity to fund its positions and meet, when due, the cash and collateral demands of counterparties, credit providers, and investors.
The amount of cash or eligible collateral an investor must deposit with a counterparty or intermediary when conducting a transaction. For example, when buying or selling a futures contract, initial margin must be deposited with a broker or clearinghouse. If the futures price moves adversely, the investor might receive a margin call—that is, a demand for additional funds or collateral (variation margin) to offset position losses in the margin account.
The valuation of a position or portfolio by reference to the most recent price at which a financial instrument can be bought or sold in normal volumes. The mark-to-market value might equal the current market value-—as opposed to historic accounting or book value—or the present value of expected future cash flows.
An intermediary that holds an inventory of financial instruments (or risk positions) and stands ready to execute buy and sell orders on behalf of customers at posted prices or on its own account. The market maker assumes risk by taking possession of the asset or position. In organized exchanges, market makers are licensed by a regulating body or by the exchange itself.
The risk that arises from possible changes in the prices of financial assets and liabilities; it is typically measured by price volatility.
Comprehensive documentation of standard contractual terms and conditions that covers a range of OTC derivatives transactions between two counterparties.
Actions of economic agents that are to their own benefits but to the detriment of others and arise when incomplete information or incomplete contracts prevent the full assignment of damages (and/or benefits) to the agent responsible. For example, under asymmetric information, borrowers may have incentives to engage in riskier activities that may be to their advantage, hut which harm the lender by increasing the risk of default.
A written contract to combine offsetting obligations between two or more parties to reduce them to a single net payment or receipt for each party. For example, two banks owing each other $10 million and $12 million, respectively, might agree to value their mutual obligation at $2 million (the net difference between $10 million and $12 million) for accounting purposes. Netting can be done bilaterally—when two parties settle contracts at net value—as is standard practice under a master agreement, or multilaterally through a clearinghouse. Closeout netting combines offsetting credit exposures between two parties when a contract is terminated.
The reference value (which is typically not exchanged) on which the cash flows of a derivatives contract are based. For example, the notional principal underlying a swap transaction is used to compute swap payments in an interest rate swap or currency swap.
Financial commitments that do not involve booking assets or liabilities, and thus do not appear on the balance sheet.
Risk of losses resulting from management failure, faulty internal controls, fraud, or human error. It includes execution risk, which encompasses situations where trades fail to be executed, or more generally, any problem in back-office operations.
A contract granting the right, and not the obligation, to purchase or sell an asset during a specified period at an agreed-upon price (the exercise price or strike price). A call option is a contract that gives the holder the right to buy from the option seller an asset at a specified price; a put option is a contract that gives the holder the right to sell an asset at a predetermined price. Options are traded both on exchanges and over-the-counter.
A market for securities where trading is not conducted on an organized exchange but through bilateral negotiations. Often these markets are intermediated by brokers and/or dealers. Examples of OTC derivatives transactions include foreign exchange forward contracts, currency swaps, and interest rate swaps.
Bonds that provide specific monetary payments if a counterparty fails to fulfill a contract, thereby providing protection against loss in the event the terms of a contract are violated.
The amount potentially at risk over the term of a derivatives contract if a counterparty defaults. It varies over lime in response to the perceived risk of asset price movements that can affect the value of the exposure.
The current exposure adjusted to reflect the cost of replacing a defaulted contract.
A derivatives contract that involves a series of exchanges of payments. Examples are agreements to exchange interest payments in a fixed-rate obligation for interest payments in a floating-rate obligation (an interest rate swap), or one currency for another (a foreign exchange swap). A cross-currency interest rate swap is the exchange of a fixed-rate obligation in one currency for a floating-rate obligation in another currency.
A statistical estimate of the potential marked-to-market loss to a trading position or portfolio from an adverse market move over a given time horizon. VaR reflects a selected confidence level; therefore, actual losses during a period are not expected to exceed the estimate more than a prespecified number of times.
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See the Glossary for definitions of special terms.
See the discussion of spillovers and contagion in International Monetary Fund (1998a).
Turnover data are less timely than data on outstanding amounts.
Gross market value is the sum of the positive market value of all contracts held by the institutions included in the survey, and the negative market value of surveyed institutions’ contracts with those not included in the survey. A portfolio of one contract worth $5 and one contract worth—$2 (a negative market value) against a non-reporting institution thus has a gross market value of $7. The overall credit risk in a derivatives portfolio is more complicated to measure, as it includes potential future exposure (see below).
A foreign exchange swap is typically a short-term deal that combines a spot sale of currency and a forward purchase. A currency swap typically has a longer maturity and involves both a spot sale and forward purchase and the periodic exchange of interest in the two currencies.
The average deal size of spot and forward transactions in the United States is approximately $4 million, whereas the average notional size of foreign exchange swaps is nearly eight times as large. Long-term transactions (one year and longer to maturity) account for less than 4 percent of traditional foreign currency derivatives turnover.
See United States, Board of Governors of the Federal Reserve System (1999), Table 5.
It recently has been noted that “hedge funds supply very necessary liquidity [in the credit derivatives market]. In many ways they are the bedrock of many modern derivative markets” (Mahtani, 1999, p. 90).
These are distinct from the formal regulatory definitions as applied by, e.g. the U.S. Securities and Exchange Commission.
Some exchange-traded contracts, such as the ‘flex options’ traded on the Chicago Board Options Exchange and Chicago Board of Trade, permit traders to customize aspects such as the expiration date and exercise price, but most exchange-traded contracts have a limited set of specifications.
See Greenspan (2000).
Marshall and Kapner (1993) describe numerous varieties of swaps.
Steinherr (1998, p. 117).
See Smithson and Hayt (1999), pp. 54–55. Credit events include default or a downgrade to sub-investment grade.
See Steinherr (1998), p. 180.
See Kroszner (1999).
Among the exceptions, in Brazil all OTC derivatives transactions must be centrally registered. See United States, Commodity Futures Trading Commission (1999), pp. 64–65.
Market terminology in this area is imprecise; some refer to clearing and settlement as “clearing,” particularly when one institution (a clearing corporation) performs both functions.
Foreign-exchange derivatives are an exception as they have been traded on electronic systems for some time. In 1999, only two of 16 jurisdictions surveyed indicated that multilateral electronic execution facilities are available for OTC transactions (see United States, Commodity Futures Trading Commission (1999)).
Informal confirmation often takes place over the telephone. Whether a verbal agreement creates a binding contract or not (in the United Kingdom, it does; elsewhere, it is less clear), firms typically tape phone conversations and store the tapes for six months to one year after the conversation takes place.
See Global Derivatives Study Group (1993), p.69.
An option is “in the money” when it is profitable to exercise.
See Kawaller (1999).
Data from the U.S. Office of the Comptroller of the Currency show that bilateral netting reduces credit exposure on derivatives among all U.S. banks by about 60 percent, and that this percentage has increased over time.
Major banks are among the providers of prime brokerage services. In March 2000, J.P. Morgan announced plans to set up a separate company (Arcordia) to offer post-trade operations associated with derivatives.
See Trant (1999).
SWIFT is a banking industry-owned payment and settlement messaging network that is operated by the Society for Worldwide Interbank Financial Telecommunications.
See International Monetary Fund (1999), pp. 69–70.
Hull (2000), Chapter 13.
If the option still has some time to go before it expires, it will be worth a bit more than $200. Part of an option’s value derives from the fact that one can wait to exercise it.
Greater sensitivity to credit risk at the longer end of the maturity spectrum may also be reflected in wider swap spreads for longer-dated swaps (Kolb (1996), pp. 146–47).
In 1993, about half the end-users and all the dealers surveyed by the CFTC reported the use of collateral to manage credit exposures (United States, Commodity Futures Trading Commission, 1993b, p. 77).
United States, General Accounting Office (1999), p. 42, notes that LTCM used rehypothecation to achieve high leverage.
See, for example, Global Derivatives Study Group (1993).
See Wallace (1994). A U.S. bankruptcy bill under consideration in 2000 sought to further clarify the U.S. legal environment for OTC derivatives.
See Global Derivatives Study Group (1993). For discussion of the legal issues surrounding the use of collateral in Europe, see International Swaps and Derivatives Association (2000).
In the EU, the implementation of the Settlement Finality Directive may clarify these issues (“Collateral Calculations,” pp. 44–47).
A recent “master master” cross-product netting agreement permits the netting of counterparty exposures across existing master agreements including for swaps, options, foreign exchange, and repos (see Cass, 2000, p. 17).
German and French counterparties often prefer master agreements written by domestic banking associations to those written by ISDA. The use of different documents for different positions can give rise to “documentation basis risk”; for example, ISDA and Bond Market Association documents might imply different valuations for the same underlying asset (Counterparty Risk Management Policy Group, 1999, p. 42).
Default is distinct from termination. Default indicates a credit problem and entitles the non-defaulting counterparty to terminate all swaps under a master agreement. Termination indicates an event other than a credit problem (say, a change in relevant law) and terminates only those swaps that are directly affected (Marshall and Kapner, 1993, pp. 198–99).
Once these valuations are obtained, the process for making a claim against the counterparty in court is the same as for any other senior claim.
For a description of Peregrine’s demise see International Monetary Fund (1998a), Box 2.10, p. 45.
For an overview of the regulatory environment in the United States see, for example, United States, Commodity Futures Trading Commission (1993a); and particularly the associated working papers 3A, 3B, and 3C, which cover the regulatory frameworks for the CFTC, the SEC, and bank regulators, respectively.
According to the 1934 Securities Exchange Act, the legal definition of a “security” is: “any note, stock, treasury stock, bond debenture, certificate of interest or participation in any profit sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit, for a security, any put, call, straddle, option or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof) or any put, call, straddle, option or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing.…” [(1932) Act § 3(a), 15 U.S.C. §78c(a) (10)].
In addition to exchange regulation, the SEC framework includes regulation of primary public offerings of securities (product registration and disclosure requirements). This is in contrast to futures regulations, where the main focus rests on transactions in the secondary exchange market since all futures transactions are required to be effected on a centralized exchange without an offering process comparable to that of securities.
A “broker” is defined in the 1934 Securities Exchange Act (SEA) as “any person engaged in the business of effecting transactions in securities for the account of others, but not a bank.”
A “dealer” is defined in the SEA as “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise, but does not include a bank, or any person insofar as he buys or sells securities for his own account, either individually or in some fiduciary capacity, but not as a part of a regular business.”
For more information on DPG, see United States General Accounting Office (1999), pp. 17 and 27.
The Securities and Futures Authority (SFA), which is now integrated into the FSA, had a similar differentiation in its rulebook. But the two approaches differ in terms of the criteria for eligibility: while the Grey Paper is essentially transactions-based, the SFA’s approach is counterparty-based.
The wholesale market regime is currently being revised in light of the new Financial Services and Markets Bill, which will formally establish the FSA as the single financial regulator in the U.K. The new “inter-professional regime” would combine the FSA’s Grey Paper Regime with the SFA’s approach to professional business. It will likely be extended to a wider range of OTC products, notably equity, commodity, and energy derivatives, and may distinguish three tiers of market participants—rather than the two-way split between professional and nonprofessional counterparties under the current regime.
The minimum size limits are (100,000 for debentures, bonds, loan stock, and sale and repurchase agreements; and an underlying notional value of (500,000 for swaps, options, futures, and forward rate agreements or any other “contract for differences” (see United Kingdom, Financial Services Authority, 1999b).
Under EU directives, a bank or non-bank investment firm incorporated and authorized in another EU Member Country may conduct the range of investment services in the United Kingdom. It is authorized by its home country regulator; further U.K. authorization is not required.
For a comprehensive overview of OTC derivatives regulations in key jurisdictions, see United States, Commodity Futures Trading Commission (1999).
A joint statement on oversight of the OTC derivatives market (March 15, 1994) by the U.S. CFTC, U.S. SEC, and the U.K. Securities and Investment Board (SIB) (which is now part of the FSA) states: “Having regard to the complexity and lack of transparency characteristic for many OTC derivatives products, the Authorities, as necessary, will encourage the development of a regulatory framework that addresses the particular suitability, know your customer or access issues arising in OTC derivatives transactions.” See United States, Commodity Futures Trading Commission (1999), p. 57.
These considerations do not apply to banks, which are regulated and supervised by the relevant U.S. banking regulator.
Registered broker-dealers have to comply with the SEC’s net capital rule which requires, for example, that swaps have to be covered by 100 percent net capital on the replacement value. In fact, this capital requirement on swaps for broker-dealers is larger than the requirement for banks, which according to the Basel Capital Accord have to hold a capital charge of at most 8 percent of the replacement value (depending on the type of counterparty)—plus a small charge to capture potential future exposure. The President’s Working Group on Financial Markets advised the SEC to explore more risk-sensitive approaches to capital for securities firms, building on the experience with the “broker-dealer lite” approach to capital for derivatives dealers (see below). See United States, President’s Working Group on Financial Markets (1999a) and United States, Securities and Exchange Commission (1997).
At four major securities and futures firms, the share of assets held outside regulated entities rose from 22 percent in 1994 to 41 percent in 1998, according to the U.S. General Accounting Office (see United States, General Accounting Office (1999)).
The U.S. President’s Working Group on Financial Markets consists of senior representatives from the Department of the Treasury, the Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures Commission.
See United States, President’s Working Group on Financial Markets (1999b), page 1 of the transmittal letters.
Far a detailed list of these swap conditions, see United States, President’s Working Group on Financial Markets (1999b).
See Summers (2000).
Several draft bills addressing the swap exclusion are currently being debated in House and Senate committees.
These derivative transactions should also be excluded from certain state laws (for example, gambling laws). The exclusion should, however, not apply to any swap agreement that involves a nonfinancial commodity with finite supply owing to concerns about possible market manipulation.
Innovation in securities-based derivatives, such as equity swaps, credit swaps, and emerging country debt swaps, may have been slowed by ambiguity about supervisory authority in the U.S. and by concerns about their legal enforceability. In fact, Federal Reserve Chairman Greenspan noted that “[t]he greatest legal uncertainty is in the area of securities-based [OTC derivative] contracts, where the CFTC’s authority is constrained.” See Greenspan (2000).
Specifically, the CFTC was given exclusive jurisdiction over contracts for the sale of a commodity for future delivery and over options on such contracts. It also regulates, though not necessarily with exclusive jurisdiction, commodity option contracts. Transactions in, or in connection with, commodity futures contracts and commodity options must be conducted in accordance with the CEA.
The CEA defines “commodity” as to include agricultural commodities and “all other goods, … and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.”
Exempt “securities” include government securities and other securities that are exempt from many of the federal securities laws.
Treasury Amendment securities (which include government securities, mortgages, and foreign currency) and options on foreign currency that trade on securities exchanges would continue to be subject to SEC jurisdiction. See United States, President’s Working Group on Financial Markets (1999b).
Parallel to clarifying the legal status of OTC derivatives, the CFTC—with support from the President’s Working Group—has been reviewing the regulation of exchange-traded financial derivatives. Key elements of this review include “a move from direct to more oversight regulation; a move from prescriptive rules to flexible performance standards; and the increased use of disclosure-based regulation” (see Rainer (2000)). A CFTC Task Force has issued a paper outlining possible measures to streamline the regulation of futures markets (see United States, Commodity Futures Trading Commission Staff Task Force (2000)).
For a more extensive discussion of supervisory Andrea regulatory aspects of credit derivatives, see Staehle and Cumming (1998).
See Box 3.5: Measuring Potential Future Exposure in a Swap Contract.
Central clearinghouses for OTC derivatives, such as the London Clearing House’s SwapClear and the OM Exchange’s facility, have garnered little interest. See Box 4.2: Clearinghouses.
Such a default could result in significant claims on other members of the clearinghouse, if the defaulting member’s margin and the clearinghouse’s own funds are exhausted.
Consider a $100 million interest-rate swap with an end-user client. If the intermediary wishes to hold only 10 percent of this exposure, it can enter an offsetting swap for $90 million with another intermediary. If, in turn, the second and each subsequent intermediary holds only 10 percent of each incoming transaction, in the limit, the initial $100 million swap gives rise to a $1 billion increase in notional outstandings and market turnover. Put differently, the initial $100 million “economically driven” transaction gave rise to $900 million in “financially driven” interdealer transactions, and correspondingly large gross (but smaller net) interdealer credit exposures. In foreign exchange markets, this has been called “hot-potato” trading. It partly explains why interbank foreign exchange turnover is much larger than the international trade and capital flows that it supports. See Lyons (1996).
See Diamond (1984).
See p. 79 in International Monetary Fund (1999).
See testimony by Federal Reserve Chairman Greenspan, SEC Chairman Levitt, and Treasury Secretary Summers before the Joint U.S. Senate Committees on Agriculture, Nutrition and Forestry, and Banking, Housing and Urban Affairs on June 21, 2000.
See pages 77–79 and 173–75 of International Monetary Fund (1999).
See Ingersoll (1989).
See Steinherr (1998).
See Chancellor (1999), p. 7.
This exchange is still in existence.
See Chancellor (1999), p. 10.
Chancellor (1999), p. 57.
Steinherr (1998). The early development of the swap may be partly due to the fact that foreign exchange exposures are relatively easy for intermediaries to hedge (and need not involve foreign exchange futures). Specifically, intermediaries can hedge foreign exchange exposures by borrowing the currency in which they are long.
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