Appendix I: Primer on Derivatives Markets36
58. A derivative is a transaction that is designed to create price exposure, and thereby transfer risk, by having its value determined—or derived—from the value of an underlying commodity, security, index, rate or event. Unlike stocks, bonds and bank loans, derivatives generally do not involve the transfer of a title or principal, and thus can be thought of as creating pure price exposure, by linking their value to a notional amount or principal of the underlying item.
59. A forward contract is the simplest and perhaps oldest form of a derivative contract. This term is used in OTC financial instrument markets to mean the obligation to buy or borrow (sell or lend) a specified quantity of a specified item at a specified price or rate at a specified time in the future. A forward contract on foreign currency might involve party A buying (and party B selling) 1,000,000 Euros for U.S. dollars at US$1.3605 on December 1, 2010. A forward rate agreement on interest rates might involve party A borrowing (party B lending) US$1,000,000 for three months (91 days) at a 2.85 percent annual rate beginning December 1, 2010. Alternatively, there is a forward markets for U.S. Treasury securities, known as the “when-issued” market, in which the forward specifies delivery following the auction of new securities notes and bonds. Under the Commodity Exchange Act, a forward contract is a cash transaction common in many industries, including commodity merchandising, in which a commercial buyer and seller agree upon delivery of a specified quality and quantity of goods at a specified future date. Terms may be more “personalized” than is the case with standardized exchange traded futures contracts (i.e., delivery time and amount are as determined between seller and buyer). A price may be agreed upon in advance, or there may be agreement that the price will be determined at the time of delivery.
60. Exchange traded futures contracts, are highly standardized and cleared through clearing houses. The futures contracts traded are so standardized that they are fungible or fully substitutable one for another on the exchange listing the contract. This enhances liquidity and facilitates trading by allowing a purchase and sale to fully offset one another.
61. In contrast to OTC traded forwards, the trading in exchange “pits” or on their electronic order matching platforms is public and multilateral. Trading in traditional pits involves the very public statement of bid and offer prices known as “open outcry.” Open outcry is not only public, but also multilateral because all market participants can hit a bid, lift an offer, or raise or lower the quote. In this environment, all market participants can observe the bid, offer and execution prices and thereby know whether the prices they are agreeing to are the best prevailing market prices.
62. Clearing houses are used to clear all exchange-traded futures and options contracts. Trades from the exchange are reported to the clearing house, and the contracts are written anew between traders and the clearing house, or novated, so that the clearing house becomes the counterparty to every contract. In a novation, two parties terminate the contract between them, and one of the parties enters into a new contract on identical terms with a new counterparty. In this manner, the clearing house assumes the credit risk of every contract traded on the exchange. While the clearing house directly ‘faces off’ with only clearing members, in doing so it provides a high quality credit guarantee on the financial performance of the derivatives contracts that it clears. Instead of having to perform a credit evaluation of every actual and potential trading partner, the futures trader has only to evaluate the creditworthiness of the clearing house and the clearing member handling the trader’s futures brokerage account, and in the case of U.S. futures exchanges, the clearing houses are all considered highly creditworthy and have never failed to pay funds due its clearing members.
63. Whereas a futures contract entails an obligation on both counterparties to transact at a specific price at a future date, an option contract gives the buyer (seller) the right to buy (sell) the underlying item at a specific price at a specific time period in the future. In the case of a call option, the owner has the right to buy the underlying item at a specified price—known as the strike or exercise price—at or before a specified time in the future. In the case of a put option, the option holder has the right to sell the underlying item at the strike or exercise price at a specified time in the future. Whereas the holder of the option has the right to exercise the option in order to buy or sell at the more favorable strike price, the writer or seller of the option (known as the short options position) has the obligation to fulfill the contract if it is exercised by the option buyer. The writer of an option is thus exposed to potentially unlimited losses. The write of a call option is exposed to losses from the market price rising above the strike price, and the writer of a put option is exposed to losses if the price of the underlying item were to fall below that of the exercise price.
64. There are several basic styles or structures of options. An American style option can be exercised at any point during a specified period which is usually the life of the contract, while European style options can be exercised only on the expiration date. An Asian option is path dependent such as ones that pay the difference between the average price and the strike or the most extreme price and the strike over the exercise period. Barrier options contain knock-out or knock-in provisions that void the contract if a price hits the knock-out point or must hit the knock-in price before the option is exercisable. Exotic options can in many forms but they are known for their complexity and difficulty to price.
65. The value or price paid to buy an option is known as the premium. It is determined by the length of time before the option expires, the volatility of the underlying item, the current market price, the strike price and the market rate of interest. Although the specifics of this relationship are more precisely expressed in closed form equations such as the Black-Scholes formula or the Binary or lattice models, the basic economic reasoning is the same. Like an insurance policy, the price paid for the option is called a premium, however the exercise value is not an indemnity and it is not dependent upon there being a specific loss or damage.
66. The swap contract is a more recent innovation in contract design. The first currency swap contract, between the World Bank and IBM, dates to August of 1981. The basic idea in a swap contract is that the counterparties agree to swap two different types of payments. Each payment is calculated by applying some interest rate, index, exchange rate, or the price of some underlying commodity or asset to a notional principal. The principal is considered notional because the swap generally does not involve a transfer or exchange of principal (except for foreign exchange and some foreign currency swaps). Payments are scheduled at regular intervals throughout the tenor or lifetime of the swap. When the payments are to be made in the same currency, then only the net amount of the payments are made.
67. There are several basic types of swaps. A “vanilla” interest rate swap is structured so that one series of payments is based on a fixed interest rate and the other series is based on a floating or variable interest rate. A foreign exchange swap is structured so that the opening payment involves buying the foreign currency at a specified exchange rate, and the closing payment involves selling the currency at a specified exchange rate. Thus it is akin to a spot transaction combined with a forward contract. A foreign currency swap is structured so that one series of payments is based on one currency’s interest rate and the other series of payments is based on another currency’s interest rate. An equity swap has one series of payments based on a long (or short) position in a stock or stock index, and the other series is based on an interest rate or a different equity position.
68. Structured notes, also known as securities, contain features of both conventional debt securities and derivatives. The term “note” usually refers to a public or private credit instrument like a bond, and may have a maturity that ranges between two and ten years. The term “structured” refers to an attached derivative or other contingent payment schedule. Structured notes are part of a broader class of financial instruments that contain features of both securities and derivatives. Examples of these instruments include familiar instruments such as callable bonds, convertible bonds and convertible preferred stock.
69. There are two basic economic purposes for derivatives markets: risk management and price discovery. Risk management, such as hedging, includes the transfer of risk from those who are less willing and able to bear it towards those who are more willing and able. Derivatives trading is not always a mere transference of risk, and it sometimes serves to eliminate risk. Consider the following two straightforward examples. A farm hedging its crop by selling short (using a forward, futures, swap or options strategy) to a food processor who is buying long, and a bank using a vanilla interest rate swap (receiving the floating rate and paying the fixed rate in order to hedge the cost of its short term funding liabilities) contract with a pension fund that is trying to increase the maturity of its fixed income portfolio. Eliminating one type of risk, in the above case market risk, creates another type, credit risk.
70. More efficient risk management promotes investment by allowing investors to take on the risks they want and avoid the ones they do not. For example, traditional banking activity focuses on the efficiency of credit evaluations in underwriting loans. Banks that are good at this activity might seek to expand their lending activity, but for the interest rate risk arising from the duration mismatch between their liabilities and loans. Hedging that risk through interest rate linked derivatives would allow the bank to concentrate on its strong suit and expand its lending activities without exposing it to greater interest rate risk.
71. One feature of derivatives markets that improves the efficiency of risk management is the greater liquidity in trading in and out of positions. Liquidity helps to lower the cost of conducting a derivatives transaction and it also facilitates the adjustment of a hedge or risk management position in response to changing circumstances. For example, if the magnitude of the pre-existing risk—such as a larger than expected crop or an unexpected drop in short-term funding needs—were to change, then the size of the hedge would need to change. An illiquid market would raise the cost of hedging and possibly thwart or make prohibitively expensive any subsequent adjustment to a hedging position. Although market trading liquidity is not necessary, it does provide significant potential hedging benefits.
72. A second basic economic purpose of derivatives market is price discovery. By dent of their lower trading costs, greater liquidity or the standardization of the reference entity, derivatives markets often serve as the primary markets for determining the prices of commodities and financial assets and the market value of certain risks and events.
73. The importance of price discovery is so profound that it was written into U.S. law. It is explicitly stated as one of the motivating reasons for regulating derivatives markets. Section 3 of the Commodity Exchange Act, entitled “The Necessity of Regulation,” stated, until being amended as part of deregulation in 2000, the following.
“‘Futures’ are affected with a national public interest. Such futures transactions are carried on in large volume by the public generally and by persons engaged in the business of buying and selling commodities and the products and byproducts thereof in interstate commerce. The prices involved in such transactions are generally quoted and disseminated throughout the United States and foreign countries as a basis for determining the prices to the producer and consumer of commodities and the products and by-products thereof and to facilitate the movements thereof in interstate commerce. Such transactions are utilized by shippers, dealers, millers, and others engaged in handling commodities … The transactions and prices of commodities on such boards of trade are susceptible to excessive speculation and can be manipulated, controlled, cornered or squeezed, to the detriment of the producer or the consumer and the persons handling commodities and products and byproducts thereof in interstate commerce, rendering regulation imperative for the protection of such commerce and the national public interest therein.”
Cecchetti, S. G., et al., 2009, “Central counterparties for over-the-counter derivatives.” BIS Quarterly Review (September 2009).
Dodd, Randall, 2009b, “Exotic Derivatives Losses in Emerging Markets: Questions of Suitability, Concerns for Stability” IMF Working Paper (forthcoming).
Fitch Ratings, 2008, “Corporate CDS Market: Current Spread and Volume Trends,” Fitch Ratings Credit Policy Special Report, August 8.
Garvy, George, 1944, “Rivals and Interlopers in the History of the New York Security Market.” Journal of Political Economy, Vol. 52, No. 2, pp. 128 –143.
Singh, Manmohan and James Aitken, 2009, Deleveraging after Lehman—Evidence from Reduced Rehypothecation. IMF Working Paper WP/09/42 (Washington, DC, International Monetary Fund).
The primary author is Randall Dodd.
Since the crisis, additional improvements have been made in the areas of portfolio reconciliation and trade compression efforts. For example, all major dealers now reconcile derivative positions daily using an automated data platform, and dealers and some end-users are currently participating in a pilot program to fine tune a new International Swaps and Derivatives Association (ISDA) dispute resolution protocol.
The BCBS’s Joint Forum on Credit Risk Transfer stated “Market participants have come to view the credit derivative indexes as a key source of pricing information on these markets. The liquidity and price transparency that indexes provide has enabled credit risk to become a traded asset class.” April 2008.
H.R. 4173, Restoring American Financial Stability Act of 2010, and the related Conference Report were passed by the House of Representatives and the Senate.
The left column is gross fair value and the right column is the net current credit exposure (NCCE) measured at the end of calendar year.
These figures now include former broker-dealers Goldman Sachs and Morgan Stanley which have reorganized themselves into bank holding companies. A historical chart would show similar degrees of concentration dating back for more than a decade.
The banks that comprise the top banks have changed over the years due to mergers and the recent rechartering of major broker-dealers like Goldman Sachs and Morgan-Stanley.
Notional amounts outstanding denotes the general level of activity or size of the market, but is not an accurate measure of risk.
A recent article in the Bank for International Settlement (BIS) Quarterly Review (Cecchetti, et al, 2009)) stated that “in order to facilitate transactions, derivatives contracts have in many cases become more standardized …interest rate swaps and foreign exchange derivatives have become highly standardized through voluntary industry initiatives.”
While economically the two are similar, semantically they differ in that the term margin is usually used to refer to the performance bond required for exchange-traded futures and options while collateral is used in the context of OTC derivatives transactions.
Here the term clearing house is used to refer an entity providing the following post-trade services: trade confirmation, netting, novation of contracts with a central counterparty (usually with an AAA credit rating), and settlement.
The term derivatives exposure is usually measured at the replacement value of the contract or contracts. This can be thought of as the present expected value of the contracts plus any additional costs of acquiring those positions in the market, e.g., paying commissions and half the bid/ask spread.
The Master Trading Agreement (MTA) and the CSA are standard documents prepared and copyrighted by the ISDA.
The concern is greater in the case of the rehypothecation of initial margins, since this does represent a credit exposure to the receiving party. Transfer of variation margin, which reflects market value gain/losses between the two parties is a lesser concern since the party’s net position is (by definition) under water.
See Citi’s “Are the Brokers Broken?” September 5, 2008, and hedge fund figure from Lehman’s bankruptcy manager PwC, Press Release September 21, 2008 and numerous related news services reporting the amounts.
In recent years though, the growing use of DTCC’s Warehouse Trust Company, trade data repository has greatly improved the reporting and record keeping of such OTC credit derivative transactions.
PIMCO published a White Paper on this problem in October 2002, which stated, “Credit default markets are the mechanism within which friendly commercial bankers and others privy to inside information can profit by betraying and destroying their clients through the use of inside information.”
See the Wall Street Journal and New York Times (March 31, 2010) reporting on New York federal court taking up the challenge to SEC authority in a case involving Deutsche Bank and Millennium Capital hedge fund.
U.S. Treasury Department, A New Foundation: Rebuilding Financial Supervision and Regulation. June 17, 2009.
The legal term for brokers in the futures markets is a Futures Commission Merchant, but the more familiar term broker will be used in this note. Also note that exchange-traded options on securities and narrow-based security indices were already regulated as securities.
Major swap participants are defined as firms with substantial positions and that are highly leveraged.
The legislation defines as swap to include the usual array of OTC derivatives contracts such as forward, option, swap and the more exotic second- and third-generation derivatives. It includes foreign-exchange based forwards and swaps. It exempts certain contracts for delivery in the future is they are settled by physical delivery.
See Section 125 of H.R. 3795.
It also prohibits state insurance authorities from regulating a credit derivative or other security-based swap as an insurance contract.
See Global Financial Stability Report (April 2010), Chapter 3, Box 3.5 on History of Central Counterparty Failures or Near-Failures.
LCH accommodates customization along several dimensions, and this defines what is an eligible contract, but certain levels of complexity are rejected as too economically costly for multilateral clearing.
See the April 2010 issue of GFSR, Chapter 3, for a longer discussion of these new clearing entities.
CFTC Chair Gary Gensler at the annual FIA industry conference, March 2010.
The risks of expected losses are supposed to be handled through credit spreads on loans and collateralization and diversification of exposures.
This mirrors similar prohibitions covering securities clearing and is intended to avoid the exercise of monopolistic power by vertically integrated trading and clearing organizations such as traditional futures exchanges.
After passage of the CFMA, the SEC retained anti-fraud authority over some securities-based swap. The Food, Conservation, and Energy Act of 2008 (known as the Farm Bill of 2008) restored to the CFTC anti-fraud authority over OTC transactions in commodities such as energy and metals, but not for financial products.
The Commodity Exchange Act, as amended in 1974, prohibits derivatives on onions and the CFMA of 2000 prohibits trading OTC derivatives on certain enumerated (i.e., listed in the Act) agricultural commodities.
For example, Chile prohibited the trading in foreign exchange options until a dealer could prove that it had sufficient risk management capabilities, such as value at risk models, to take on the risks inherent in such market making.
Binding market making requirements are not unusual. The New York Federal Reserve Bank requires that primary dealers in the U.S. Treasury securities markets maintain binding quotes in Treasury securities through the trading day. OTC markets in equity shares have designated dealers that are required to similarly maintain binding bid and offer quotes throughout the trading day.