Derivatives Market

The derivatives market is the market for financial instruments derived from another asset. Futures and options contracts are one example of derivatives.

A derivatives market may be exchange regulated or over-the-counter. Not only is the legal nature of both different, there is also a difference in the way they are traded. Regardless, traders or participants are active in both markets.

Exchange Traded Derivatives

Exchange traded derivative products are standardized contracts such as futures and options and are traded in recognized exchanges such as Euronest.liffe and the Chicago Mercantile Exchange. Exchanges like these offer futures and options contracts based on a wide range of underlying assets including stocks, commodities and currency. The exchange acts as a central counterparty to all contracts. If a party buys (or goes long) the other sells (goes short) meaning that the sum of all positions in a particular contract is always zero. The magnitude and growth of the derivatives market can be gauged by the fact that the notional amount of all outstanding positions at end June 2004 was US$53 trillion, which jumped to US$ 80 trillion by the end of March 2008 (Source: BIS – Bank for International Settlements).

Over-the Counter Market

Commonly known as OTC, these markets offer customized derivatives that are not traded in exchanges. These markets comprise of investment banks that have market makers as traders and clients such as large hedge funds, commercial banks, etc. A market maker is an individual or a company that offers prices at which it will buy or sell a financial instrument such as derivatives (or a commodity held in inventory) hoping to make a profit on the bid-offer spread. Derivatives traded in over-the-counter markets are forward rate agreements, futures contracts, credit derivatives, accumulators, swaps etc. The over-the-counter derivatives market is even larger than exchange traded market. As per BIS, the total notional outstanding positions on end June were US$ 220 trillion, a figure that rose to US$ 596 trillion by end of 2007 and US$ 615 trillion in 2009.

Global Netting

There were in total 975 commercial banks holding derivative positions and their second quarter 2008 revenues amounted to $ 1.6 billion. The US figure for notional amount of all derivatives for the second quarter, 2008 was $ 182.2 trillion, 80% of which comprised of interest rate contracts ($145 trillion) and foreign exchange contracts amounted to $18.2 trillion (10%).

Since the last triennial survey held in 2004, positions in the over-the-counter derivatives market have increased at an extremely fast rate. Outstanding positions in various financial instruments (notional amount) totaled US$ 516 trillion at the end of 2007, which as 135% higher than the figure recorded in 2004. This translates into an effective annualized growth rate of 33%. The growth rate from 2004 through 2007 is more than the average growth rate of 25% recorded when OTC derivatives were first surveyed by the Bank of International Settlements in 1995.

Notional amounts of outstanding positions in OTC simply provide information regarding the structure of the OTC derivatives market and are in no way reflective of trading risks. The cost of replacing all open contracts at current market prices or gross market values has increased by 74% to $11 trillion from 2004 through 2007.

Derivatives Market and the Financial Crisis of 2007-2010

The derivatives market has earned a bad name for itself because of its alleged role in the economic crisis of 2007-2010. The derivatives market is a leveraged market, which is accused of having promoted irrational appetite for risk. In addition, absence of a central clearing mechanism has been seen as having created a damaging imbalance in the market. All this is evident from the financial market reforms proposed by the G-20 nations. These proposals include:

  • Higher capital adequacy requirements.
  • Global surveillance of operations of financial institutions.
  • Action oriented rules pertaining to capital.
  • Better risk management.