February 3, 2015
Introduction to Financial Services: Derivatives
Background

take a long position (longs), interact with those who want to
sell, or go short (shorts), and deals are made and prices
Derivatives are financial instruments that come in several
reported throughout the day. In the OTC market, contracts
different forms, including futures, options, and swaps. A
are made bilaterally, typically between a dealer and an end
derivative is a contract that derives its value from some
user, and there is generally no requirement that the price,
underlying asset at a designated point in time. The
the terms, or even the existence of the contract be disclosed
derivative may be tied to a physical commodity, a stock
to a regulator or to the public. Figure 1 shows the
index, or an interest rate, for example. Derivatives’ prices
differences.
fluctuate as the underlying assets’ rates or expected future
prices change, and neither a buyer nor a seller of a
Figure 1. Exchange-traded vs. OTC Derivatives
derivative need necessarily own the underlying asset.
Many firms use derivatives to manage risk. For example, a
firm can protect itself against increases in the price of a
commodity that it uses by entering into a derivative contract
that will gain value if the price of the commodity rises. A
notable instance of this type of hedging strategy was a
derivatives position taken by Southwest Airlines that
allowed it to buy jet fuel at a low fixed price in 2008 even
as energy prices reached record highs. When used to hedge
risk, derivatives can protect businesses (and sometimes
their customers as well) from unfavorable price shocks.

Others use derivatives to seek profits by betting on which
Source: CRS.
way prices will move. Such speculation adds liquidity to the
market—speculators assume risks that hedgers wish to
Derivatives can be volatile contracts characterized by a high
avoid.
degree of leverage, which can result in big gains and losses
among traders. The exchanges deal with the issue of credit
Although derivatives trading has its origins in agriculture,
risk through a third-party clearinghouse. Once the trade is
today most derivatives are linked to financial variables,
made on the exchange floor (or electronic network), it goes
such as interest rates, foreign exchange, stock prices and
to the clearinghouse, which guarantees payment to both
indices, and the creditworthiness of bond issuers. The
parties. The process is shown in Figure 1. Traders then do
market is measured in the hundreds of trillions of dollars,
not have to worry about counterparty default: the
and billions of contracts are traded annually.
clearinghouse stands behind all trades. The clearinghouse
ensures that it can meet its obligations by collecting margin
Growth in derivatives markets was explosive between 2000
collateral—such as cash or Treasury securities—from
and the advent of the financial crisis, with some
trading counterparties if potential losses accumulate. The
retrenchment after 2008. From 2000 until the end of 2008,
intended effect of the margin system is that no one builds
the volume of derivatives contracts traded on exchanges,
up a paper loss large enough to damage the clearinghouse in
such as futures exchanges, and the notional value of total
case of default. It is certainly possible for a trader to lose
contracts traded in the over-the-counter (OTC) market grew
large amounts of money trading on the exchanges, but only
by 475% and 522%, respectively.
on a “pay as you go” basis.
Market Structure and Regulation
In the OTC market, as shown in the right side of Figure 1,
there is a network of dealers rather than a centralized
Prior to passage of the Dodd Frank Act (P.L. 111-203) in
exchange. Firms that act as dealers stand ready to take
2010, futures and options were traded on regulated
either long or short positions, and make money on the
exchanges, while swaps were traded OTC. Futures
volume of trading by charging a spread, or fee, on each
contracts have long been traded on exchanges regulated by
trade. The dealer absorbs the credit risk of customer default,
the Commodity Futures Trading Commission (CFTC), and
while the customer faces the risk of dealer default. The
stock options on exchanges under the Securities and
OTC market has been dominated by a dozen or so large
Exchange Commission (SEC).
firms—institutions like JP Morgan Chase, Goldman Sachs,
Citigroup, and their foreign counterparts. In the OTC
Exchanges are centralized markets where buying and
market, some contracts require collateral or margin, but not
selling interest comes together. Traders who want to buy, or
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Introduction to Financial Services: Derivatives
all. All contract terms are negotiable. A trade group, the
exchange or an exchange-like electronic platform called a
International Swaps and Derivatives Association (ISDA)
“swap execution facility.” However, swaps in which one
publishes best practice standards for use of collateral, but
counterparty is a nonfinancial firm (e.g., a farmer, energy
compliance is voluntary.
company, or airline) are not subject to these clearing and
exchange-trading requirements. Third, all swaps must be
Derivatives in the Financial Crisis
reported to a database called a “swap data repository.”
Fourth, financial firms that trade swaps heavily must
Because there is no universal, mandatory system of margin,
register with the CFTC or the SEC (the latter if they trade
large uncollateralized losses can build up in the OTC
swaps related to securities) as a swap dealer or as a major
market. A well-known example during the crisis was AIG,
swap participant. Fifth, any swaps not cleared are subject to
which wrote about $1.8 trillion worth of derivatives,
margin and capital requirements set by the regulators.
including credit default swaps guaranteeing payment if
certain mortgage-backed securities defaulted or experienced
other “credit events.” As the subprime crisis worsened, AIG
Modification to Dodd Frank
was subject to contract-based margin calls that it could not
H.R. 26, which extended the Terrorism Risk Insurance Act
meet. To avert disorderly failure with associated
(TRIA), was enacted into law on January 12, 2015, as P.L. 114-1.
widespread collateral damage to global financial markets,
Section 302 of the new law contains a provision on derivatives
the Federal Reserve and the Treasury put tens of billions of
regulation. This provision prevents regulators from imposing
dollars into AIG, much of which went to its derivatives
margin requirements on uncleared swaps for both trading
counterparties. AIG eventually repaid these funds with
counterparties if at least one of them is a non-financial firm.
interest.
The AIG case illustrates two aspects of OTC markets that
Current Issues for Congress
were central to derivatives reform. First, in a market with
mandatory clearing and margin, in which AIG would have
Several bills have been introduced in the 114th Congress
been required to post initial margin to cover potential
proposing changes to derivatives regulation. H.R. 37, the
losses, there is a stronger possibility that AIG would have
Promoting Job Creation and Reducing Small Business
run out of money long before the size of its position
Burdens Act (commonly referred to as the financial reform
reached $1.8 trillion.
bill), was passed by the House on January 14, 2015, and
includes several derivatives provisions. Section 201 of H.R.
Second, because most OTC contracts were not reported to
37 would exempt swaps traded between an affiliate of a
regulators prior to 2010, the Fed and the Treasury lacked
nonfinancial firm and another company from the clearing
information in the crisis about which institutions were
and exchange-trading requirements. Separately, Title V of
exposed to AIG, and the size of those exposures.
H.R. 37, the Swap Data Repository and Clearinghouse
Uncertainty among market participants about the size and
Indemnification Corrections, would remove a requirement,
distribution of potential derivatives losses flowing from the
added in the Dodd Frank Act, that foreign regulators
failure of a major dealer was a factor that exacerbated the
indemnify a U.S-based swap data repository for any
“freezing” of credit markets during the peak of the crisis.
expenses arising from litigation related to a request for
market data. This provision was originally passed by the
One basic theme of derivatives reform proposals in the
House in the 113th Congress as H.R. 742 on June 12, 2013.
runup to the Dodd Frank Act was to get the OTC market to
H.R. 37 also contains in Title I a derivatives provision
act more like the exchange market—in particular, to have
identical to that in P.L. 114-1 discussed above.
bilateral OTC swaps cleared by a third-party clearing
organization. Clearing was expected to reduce counterparty
In addition, the congressional committees with oversight of
risk and increase transparency. At the same time, there are
the CFTC, the House and Senate Agriculture Committees,
costs associated with a clearing regime that requires
may examine various derivatives regulatory issues as part
participants to post margin. Firms that use derivatives to
of the CFTC reauthorization process. This process occurs
hedge business risks take positions that move in the
roughly every five years and is currently underway, as the
opposite direction to the underlying market. Such
last authorization of appropriations for the CFTC expired
commercial businesses argued that the costs of posting
on September 30, 2013. In practice, prior extensions of the
margin would prevent them from hedging, and they were
expiring authorization provisions have often been used as
ultimately exempted from the clearing and exchange-
vehicles to amend other aspects of the Commodity
trading requirements in the Dodd Frank Act.
Exchange Act, which governs derivatives regulation.
Dodd Frank Reforms
Rena S. Miller, rsmiller@crs.loc.gov, 7-0826

The Dodd Frank Act added five broad requirements, with
IF10117
certain exceptions, aimed at bringing the swaps market
under a regulatory regime more closely resembling that of
the futures markets. First, most swaps are required to be
cleared through a clearinghouse, which involves posting
margin to cover any potential losses as they accumulate.
Second, these swaps are also required to be traded on an
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