01.3 OTC Derivatives

What is Derivatives?
  • Synthetic instrument
  • Derive value from underlying asset
  • Rice derivatives traded in Japan at 15th century
  • Stock options traded in 1800s
  • Corn and wheat futures traded on CME today
Type of Derivatives
  • Common type of derivatives
    – Futures
    – Options
    – Forwards
    – Warrants
    – Swaps
Purpose of OTC Derivatives
  • Hedging
  • Investment
  • Exposure to different market
  • Speculation
  • Leverage
  • Risk transfer
How are derivatives traded?

  • Exchange traded
    – Exchange central clearing house (CCH) acts as counterparty on both sides of the transaction
    – Credit risk exposure to CCH
    – Margin as required by CCH rules
    – Limited number of standardized products
  • Over the counter, OTC
    – Private transaction between two parties creates counterparty
    – Credit risk to be managed
    – Collateral negotiated between the parties
    – Huge variety of products
  • The market for OTC derivatives is significantly larger than for exchange-traded derivatives and was largely unregulated.
    – The Dodd-Frank Wall Street Reform and Consumer Protection Act prescribed new measures to regulate derivatives trading.
  • The OTC market is composed of banks and other sophisticated market participants.
    – The hedge funds, and because there is no central exchange, traders are exposed to more counterparty risk.
  • Most of the world’s derivatives trading takes place in the over-the-counter or privately-negotiated markets.
    – This occurs for a number of reasons, including the diverse nature of derivatives contracts, which makes it difficult to match buyers and sellers in an exchange-like trading protocol.
Why OTC?

  • OTC derivatives are a widely used risk management tool that can be closely tailored to manage a client’s specific exposures
    – Mandatory clearing is incompatible with customization
  • Offsetting an exposure through a customized OTC derivative eliminates unwanted FX, interest rate, or commodity price risk from an underlying transaction and allows companies to focus on their primary business risks.
    – Customized need not mean complex; OTC derivatives can be tailored to match both simple and complex underlying risks
  • The hedge accounting rules which require a close fit between a hedge and the underlying risk, highlighting the need for customized OTC
    derivatives
    – Mandatory clearing or exchange trading reduce the benefits of hedge accounting, including managing earnings volatility
  • Clearing houses manage default risk of their members primarily by means of cash collateral posted by members funds
    – Initial (up-front) margin
    – Daily mark-to-market and variation margin
    – Under most clearing arrangements, margin has to be posted in cash or treasury securities and adjusted for market moves twice per day
    – Additional protection provided by strict membership requirements and guarantee funds
  • In over-the-counter derivatives, collateral arrangements are common but subject to negotiation
    – For non financial companies, collateral arrangement can be tailored to include use of illiquid assets like plants, machinery, and real
    estate to avoid using cash needed for daily operations
    – For the economy as a whole, mandatory clearing, with its requirement to post cash margin, would drain liquidity and create additional
    operational burdens to corporate clients
Exchange traded vs OTC
  • Exchange traded
    – Standardized contracts
    – Limited tenor
    – Limited liquidity in deferred periods
    – Higher basis risk because of inability to customize hedge
    – Upfront collateral requires that cash to be tied up
    – Daily margin calls depend on requirement
    – Potential market movement following execution on exchange
  • Over the counter, OTC
    – Enables client to customize hedges
    – Volumes
    – Settlement timing
    – Payment timing
    Larger array of products
    – Ability to execute larger
    – volumes at one price; avoid moving the market
    – Flexible collateral: reduces or eliminates need to tie up liquidity (i.e. cash)
The importance OTC Derivatives

  • Trade Customization
    – Buyer and seller can create truly unique transactions to meet their respective needs.
    – These are commonly called, ‘bespoke’ trades.
  • Liquidity and Transparency
    – While we think about liquidity, we most often think about exchange markets, but how many exchange based markets can take a single trade to create or offset $100 Million or more in market exposure with close to zero market impact?
    – Those OTC derivatives that have combined this ‘liquidity’ with market standardization have exploded.

  • Lower costs
    – Transaction costs, like stamp taxes and exchange fees, can be eliminated when trading in OTC derivatives.
    – In addition, most derivative trades require a small ante, thus, providing a way for managers to own the same underlying market exposure at minimal cost.
  • Efficient lower footprint portfolio management
    – OTC derivatives can allow for more efficient management.
    – For example, a manager can either ‘tip their hat’ and buy hard equities or be more elusive via a contract-for-difference at one tenth the cost.
    – The time for a manager to create these exposures can be significant through traditional markets, while exposure via a CFD can take minutes.
Recent Improvements in the OTC Derivatives Market
  • Foreword
    This is the third progress report by the FSB on OTC Derivatives markets reform implementation. In September
    2009, G20 Leaders agreed in Pittsburgh that: All standardised OTC derivative contracts should be traded on
    exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end
    2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared
    contracts should be subject to higher capital requirements. We ask the FSB and its relevant members to assess
    regularly implementation and whether it is sufficient to improve transparency in the derivatives markets,
    mitigate systemic risk, and protect against market abuse.
    In June 2010, G20 Leaders reaffirmed their commitment to achieve these goals. In its October 2010 report on
    Implementing OTC Derivatives Market Reforms (the October 2010 Report), the FSB made 21 recommendations
    addressing practical issues that authorities may encounter in implementing the G20 Leaders’ commitments.
  • Over-the-Counter Trading, Exchange Trading, and Clearing
    – Over-the-counter derivatives are subjected to centrally cleared if both parties decide to assign the trade to a central counterparty, and if the central counterparty accepts the assignment.
    – Regulators have prioritized the increased use of central clearing for OTC derivatives trades in order to reduce systemic risk.
  • Counterparty credit risk can often be reduced by “clearing,” which means obtaining the effect of a guarantee by a central counterparty (CCP), sometimes called a clearing house
    – The NYMEX has created a clearing mechanism for a slate of commonly traded OTC energy derivatives which allow counterparties of many bilateral OTC transactions to mutually agree to transfer the trade to ClearPort, the exchange’s clearing house, thus eliminating credit and performance risk of the initial OTC transaction counterparts.

Clearing trades through a Central Counterparty

  • Trades executed bilaterally or on an exchange
  • Both sides or the exchange will submit the trades to a central counterparty
  • Result: central counterparty becomes party to each side of the trade
OTC Derivatives in Modern Banking
  • OTC derivatives are the significant part of world global finance at this 21st century.
  • The ability to use them to unbundle financial risk into separate components is an important step in the
    direction of creating more complete and efficient financial markets.
  • OTC derivatives enable economic agents to define more precisely their risk preferences and tolerances, and
    more effectively to manage them
Conclusion
  • Comprehensive regulation of financial markets, including increased transparency of derivative
  • The recent development in OTC derivatives in central clearing system has ensure that the transactions are
    covered by a multi-tiered clearing guarantee system which ensures the safety of payment by the parties
  • The greater freedom of negotiation and customization of the transaction of OTC derivatives has a vital role
    in the development of any countries economies.

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