Introduction to Financial Services: Derivatives

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Updated January 8, 2019
Introduction to Financial Services: Derivatives
Background
terms, or even the existence of the contract be disclosed to a
regulator or to the public. Figure 1 shows the differences.
A derivative is a contract that derives its value from some
underlying asset at a designated point in time. For example,
Figure 1. Exchange-Traded Versus OTC Derivatives
the derivative may be tied to a physical commodity (such as
cattle, wheat, or oil), a stock index, or an interest rate.
Derivatives’ prices fluctuate as the underlying assets’ rates
or expected future prices change, and neither a derivative’s
buyer nor seller need necessarily own the underlying asset.
Derivatives come in several different forms, including
futures, options, and swaps.
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
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notable instance of this type of hedging strategy was a
derivatives position taken by Southwest Airlines that
Derivatives can be volatile contracts characterized by a high
allowed it to buy jet fuel at a low fixed price in 2008 even
degree of leverage, which can result in big gains and losses
as energy prices reached record highs. When used to hedge
among traders. The exchanges deal with the issue of credit
risk, derivatives can protect businesses (and sometimes
risk through a third-party clearinghouse. Once the trade is
their customers as well) from unfavorable price shocks.
made on the exchange floor (or electronic network), it goes
to the clearinghouse, which guarantees payment to both
Others use derivatives to seek profits by betting on which
parties. The process is shown in Figure 1. Traders then do
way prices will move. Such speculation may add liquidity
not have to worry about counterparty default: the
to the market—speculators assume risks that hedgers seek
clearinghouse stands behind all trades. The clearinghouse
to avoid—but may also concentrate risk (discussed below).
ensures that it can meet its obligations by collecting daily
margin (sometimes called collateral)—such as cash or
Although derivatives trading has its origins in agriculture,
Treasury securities—from trading counterparties if
today most derivatives are linked to financial variables,
potential losses accumulate. The intended effect of margin
such as interest rates, foreign exchange, stock prices and
is to prevent paper losses large enough to damage the
indices, and the creditworthiness of bond issuers. The
clearinghouse in case of default. It is certainly possible for a
market is measured in the hundreds of trillions of dollars,
trader to lose large amounts of money trading on the
and billions of contracts are traded annually.
exchanges, but only on a “pay as you go” daily basis.
Growth in derivatives markets was explosive from 2000
In the OTC market, as shown on the right side of Figure 1,
until the end of 2008—the volume of derivatives contracts
there is a network of dealers rather than a centralized
grew by approximately 500% by some measures—with
exchange. Firms that act as dealers stand ready to take
some retrenchment after 2008.
either long or short positions, and make money on the
Market Structure and Regulation
volume of trading by charging a spread, or fee, on each
trade. The dealer absorbs the credit risk of customer default,
Prior to passage of the Dodd-Frank Act (P.L. 111-203) in
and the customer faces the risk of dealer default. The OTC
2010, futures and options were traded on regulated
market has been dominated by a dozen or so large financial
exchanges and swaps were traded over the counter (OTC).
firms—broadly, the largest U.S. banks—and their foreign
Futures contracts have long been traded on exchanges
counterparts. In the OTC market, some contracts, but not
regulated by the Commodity Futures Trading Commission
all, require collateral or margin. All contract terms are
(CFTC), and stock options on exchanges regulated by the
negotiable. A trade group, the International Swaps and
Securities and Exchange Commission (SEC).
Derivatives Association (ISDA), publishes best practice
standards for use of collateral, but compliance is voluntary.
Exchanges are centralized markets where buying and
selling interests come together. Traders who want to buy, or
Derivatives in the 2008 Financial Crisis
take a long position (longs), interact with those who want to
Because there was no universal, mandatory system of
sell, or go short (shorts), and deals are made and prices
margin, large uncollateralized losses built up in the OTC
reported throughout the day. In the OTC market, contracts
market in the run-up to the 2008 financial crisis. For
are made bilaterally, typically between a dealer and an end
example, AIG, a well-known example during the crisis,
user, and there is generally no requirement that the price,
wrote about $1.8 trillion worth of derivatives, including
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Introduction to Financial Services: Derivatives
credit default swaps guaranteeing payment if certain
Selected Issues for Congress
mortgage-backed securities defaulted or experienced other
CFTC Reauthorization. In the 116th Congress, the House
“credit events.” As the subprime crisis worsened, AIG was
and Senate Agriculture Committees, which have CFTC
subject to contract-based margin calls that it could not meet.
jurisdiction, may examine derivatives regulatory issues as
To avert disorderly failure with associated widespread
part of the CFTC reauthorization process. CFTC’s
collateral damage to global financial markets, the Federal
authorization of appropriation is in the Commodity
Reserve and the Treasury put tens of billions of dollars into
Exchange Act (CEA), but that authorization expired on
AIG, much of which went to its derivatives counterparties.
September 30, 2013. Congress has continued to fund the
AIG eventually repaid these funds with interest.
CFTC beyond the expiration of its authorization. Prior
extensions of the CEA authorization provision have been
The AIG case illustrates two aspects of OTC markets that
used as vehicles to amend other aspects of the CEA. The
were central to derivatives reform. First, in a market with
House passed a CFTC reauthorization bill, H.R. 238, in the
mandatory clearing and margin, in which AIG would have
115th Congress, but the Senate did not consider the bill.
been required to post initial margin to cover potential
losses, there is a stronger possibility that AIG would have
Nomination of CFTC Chair. The term of the current
run out of money long before the size of its position
CFTC Chair, J. Christopher Giancarlo, expires in April
reached $1.8 trillion. Second, because most OTC contracts
2019. On December 11, 2018, the White House announced
were not reported to regulators prior to 2010, the Fed and
that it would nominate Heath Tarbert, Assistant Secretary
the Treasury lacked information in the crisis about which
for International Markets at the Treasury Department, as the
institutions were exposed, and by how much, to AIG and to
next Chair. The Senate Committee on Agriculture,
Lehman Brothers, a large OTC derivatives dealer that failed
Nutrition and Forestry may hold nomination hearings.
in September 2008. Uncertainty among market participants
about the size and distribution of potential derivatives
Cross-Border Trades and Clearinghouse Equivalence.
losses flowing from the failure of Lehman, and faced by
The United Kingdom’s (UK’s) vote to leave the European
AIG, exacerbated the “freezing” of credit markets in the
Union (EU) cast uncertainty over prior agreements between
crisis.
the United States, UK, and EU that would have recognized
one another’s derivatives clearinghouses and exchanges as
One basic theme of derivatives reform proposals in the run-
“equivalent” for meeting each other’s regulatory
up to the Dodd-Frank Act was to get the OTC market to act
requirements. Most derivatives trades are “cross-border” in
more like the exchange market—in particular, to have
that they often involve a non-U.S. participant or non-U.S.
bilateral OTC swaps cleared by a third-party clearing
trading venue, and without these agreements, one cross-
organization. Clearing was expected to reduce counterparty
border trade could be subject to two different—and
risk and increase transparency. At the same time, there are
potentially conflicting—sets of requirements. Although this
costs associated with a clearing regime that requires
issue involves negotiation between the CFTC and the EU,
participants to post margin, since margin ties up cash and
due to the massive size of the markets involved, Congress
securities. Firms that use derivatives to hedge business risks
may continue to closely monitor the issue.
take positions that move in the opposite direction to the
underlying market. Such commercial businesses argued that
Cryptocurrencies. The question of whether, and how,
the costs of posting margin would prevent them from
cryptocurrencies should be regulated has drawn much
hedging, and they were ultimately exempted from the
congressional and regulatory attention that may continue in
clearing and exchange-trading requirements in Dodd-Frank.
the 116th Congress. Since 2015, the CFTC has relied on the
CEA’s anti-fraud provision to combat fraudulent conduct in
Dodd-Frank Reforms
connection with sales of virtual currencies. However, Chair
The Dodd-Frank Act added five broad requirements, with
Giancarlo noted in 2018 testimony that the CFTC lacks
certain exceptions, aimed at bringing the swaps market
broader regulatory authority—apart from its powers to
under a regulatory regime more closely resembling that of
police against fraud and manipulation—over the trading of
spot “commodities,”
the futures markets. First, most swaps are required to be
by contrast to derivatives on those
cleared through a clearinghouse, which involves posting
commodities. In May 2018, the CFTC issued a staff
margin to cover any potential losses as they accumulate.
advisory providing guidance to derivatives exchanges and
Second, these swaps are also required to be traded on an
clearinghouses registered with the CFTC on best practices
exchange or an exchange-like electronic platform called a
for listing derivatives on virtual currencies. A few options
swap execution facility. However, swaps in which one
and futures exchanges offer derivatives trading on
counterparty is a nonfinancial firm (e.g., a farmer, energy
cryptocurrencies with CFTC approval, and the CFTC has
company, or airline) are not subject to these clearing and
taken enforcement action against unregistered Bitcoin
exchange-trading requirements. Third, all swaps must be
futures exchanges. Two bills introduced in the 115th
reported to the “swap data repository” database. Fourth,
Congress would have required the CFTC to submit reports
financial firms that trade swaps heavily must register with
to Congress on topics including, respectively, (1) price
the CFTC or the SEC (the latter if they trade swaps related
manipulation in virtual currencies (H.R. 7224) and (2)
to securities) as a swap dealer or as a major swap
regulation of virtual currency markets in the United States
participant. Fifth, any swaps not cleared are subject to
as compared with other countries (H.R. 7225).
margin and capital requirements set by the regulators.
Rena S. Miller,
IF10117
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Introduction to Financial Services: Derivatives


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