2
Derivatives

2.1 INTRODUCTION

Derivatives transactions represent contractual agreements either to make payments or to buy or sell an underlying security at a time or times in the future. The times may range from a few weeks or months (for example, futures contracts) to many years (for example, long-dated swaps). The value of a derivative will change with the level of one or more underlying assets or indices and possibly decisions made by the parties to the contract. In many cases, the initial value of a traded derivative will be contractually configured to be zero for both parties at inception.

Derivatives are not a particularly new financial innovation; for example, in medieval times, forward contracts were popular in Europe. However, derivatives products and markets have become particularly large and complex in the last three decades. One of the advantages of derivatives is that they can provide very efficient hedging tools. For example, consider the following risks that an institution, such as a corporate, may experience:

• Interest rate risk. They need to manage liabilities such as transforming floating- into fixed-rate debt via an interest rate swap.
• Foreign exchange (FX) risk. Due to being paid in various currencies, there is a need to hedge cash inflow in these currencies, for example, using FX forwards.
• Commodity risk. The need to lock in commodity prices either due to consumption (e.g. airline fuel costs) or production (e.g. a mining company) via commodity futures or swaps.

In many ways, derivatives are no different from the underlying cash instruments. They simply allow one to take a very similar position in a synthetic way. For example, an airline wanting to reduce its exposure to a potential rise in oil price can buy oil futures, which are cash-settled and therefore represent a very simple way to go 'long oil' (with no storage or transport costs). An institution wanting to reduce its exposure to a certain asset can do so via a derivative contract (such as a total return swap), which means it does not have to sell the asset directly in the market.

There are many different users of derivatives such as sovereigns, central banks, regional/local authorities, hedge funds, asset managers, pension funds, insurance companies, and non-financial corporations. All use derivatives as part of their investment strategy or to hedge the risks they face from their business activities. Due to the particular hedging needs of institutions and related issues, such as accounting, many derivatives are relatively bespoke. For example, a corporation wanting to hedge the interest rate risk in a floating-rate loan will want an interest rate swap precisely matching the terms of the loan (e.g. maturity, payment frequency, and reference rate).

Financial institutions, mainly banks, provide derivative contracts to their end user clients and hedge their risks with one another. Whilst many financial institutions trade derivatives, many markets are dominated by a relatively small number of large counterparties (often known as 'dealers'). Such dealers represent key nodes of the financial system. For example, there are currently around 35 globally-systemically-important banks (G-SIBs), which is a term loosely synonymous with 'too big to fail'. G-SIB banks are subject to stricter rules, such as higher minimum capital requirements.

During the lifetime of a derivatives contract, the two counterparties have claims against each other, such as in the form of cash flows that evolve as a function of underlying assets and market conditions. Derivatives transactions create counterparty credit risk (counterparty risk) due to the risk of insolvency of one party. Counterparty risk refers to the possibility that a counterparty may not meet its contractual requirements under the contract when they become due.

Counterparty risk is managed over time through clearing; this can be performed bilaterally, where each counterparty manages the risk of the other, or centrally through a central counterparty (CCP). As the derivatives market has grown, so has the importance of counterparty risk. Furthermore, the lessons from events such as the bankruptcy of Lehman Brothers have highlighted the problems when a major player in the derivatives market defaults. This, in turn, has led to an increased focus on counterparty risk and related aspects.

2.2 THE DERIVATIVES MARKET

2.2.1 Exchange-traded and OTC Derivatives

Within the derivatives markets, many of the simplest products are traded through exchanges. A derivatives exchange is a financial centre (Figure 2.1) where parties can trade standardised contracts such as futures and options at a specified price. An exchange promotes market efficiency and enhances liquidity by centralising trading in a single place, thereby making it easier to enter and exit positions. Exchange-traded derivatives are standardised contracts (e.g. futures and options) and are actively traded. It is easy to buy a contract and sell the equivalent contract to terminate ('close') the position, which can be done via one or more derivative exchanges. Prices are transparent and accessible to a wide range of market participants.

Figure 2.1 Illustration of exchange-traded and bilaterally-traded derivatives.

Compared to exchange-traded derivatives, OTC derivatives tend to be less-standard structures and are typically traded bilaterally (i.e. between two parties). Since there is no third party involved, they are traditionally private contracts and are often not actively traded in any secondary market. However, their main advantage is their inherent flexibility, as they do not need to be standardised and, in theory, any transaction terms can be accommodated. For example, a customer wanting to hedge their production or use of an underlying asset at specific dates may do so through a customised OTC derivative. Such a hedge may not be available on an exchange, where the underlying contracts will only allow certain standard contractual terms (e.g. maturity dates) to be used. A customised OTC derivative may be considered more useful for risk management than an exchange-traded derivative, which would give rise to additional 'basis risk' (in this example, the mismatch of maturity dates). It has been reported that the majority of the largest companies in the world use derivatives in order to manage their financial risks.1 Due to the bespoke hedging needs of such companies, OTC derivatives are commonly used instead of their exchange-traded equivalents.

Customised OTC derivatives are not without their disadvantages, of course. A customer wanting to unwind a transaction and avoid future counterparty risk must do it with the original counterparty, who may quote unfavourable terms due to their privileged position. Even assigning or 'novating' the transaction to another counterparty typically cannot be done without the permission of the original counterparty. This lack of fungibility in OTC transactions can also be problematic. This aside, there is nothing wrong with customising derivatives to the precise needs of clients, as long as this is the sole intention. However, providing a service to clients is not the only role of OTC derivatives: some are contracted for regulatory arbitrage or even (arguably) misleading a client. Such products are clearly not socially useful and generally fall into the (relatively small) category of exotic OTC derivatives which in turn generate much of the criticism of OTC derivatives in general.

OTC markets work very differently compared to exchange-traded ones, as outlined in Table 2.1. OTC derivatives are traditionally privately negotiated and traded directly between two parties without an exchange or other intermediary involved (between a dealer and end user or between two dealers). OTC markets did not historically include trade reporting, which is difficult because trades can occur in private, without the activity being visible in any way (such as to an exchange). Legal documentation is also bilaterally negotiated between the two parties, although certain standards have been developed.

Table 2.1 Comparison between exchange-traded and OTC derivatives.

• Standardised (maturity, size, strike, etc.)

• Flexible and negotiable

• Standard maturities, typically at most a few months

• Negotiable and non-standard
• Often many years

• Very good

• Limited and sometimes very poor for non-standard or complex products

2.2.2 Clearing

After a transaction is executed, and before it has been settled, there is the question of clearing (Figure 2.2). An OTC derivative contract legally obliges its counterparties to make certain payments over the life of the contract (or until an early termination of the contract). These payments are in relation to buying or selling certain underlying securities or exchanging cash flows in reference to underlying market variables. Settlement refers to the completion of all such legal obligations and can occur when all payments have been successfully made or alternatively when the contract is closed out...