Derivatives market
Encyclopedia
The derivatives market is the financial market
for derivative
s, financial instruments like futures contracts or options, which are derived from other forms of assets.
The market can be divided into two, that for exchange-traded derivatives and that for over-the-counter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both.
, trade in standardized derivative contracts. These are options contracts
and futures contract
s on a whole range of underlying
products. The members of the exchange hold positions in these contracts with the exchange, who acts as central counterparty
. When one party goes long
(buys a futures contract), another goes short (sells). When a new contract is introduced, the total position in the contract is zero. Therefore, the sum of all the long positions must be equal to the sum of all the short positions. In other words, risk is transferred from one party to another. The total notional amount
of all the outstanding positions at the end of June 2004 stood at $53 trillion. (source: Bank for International Settlements
(BIS): http://www.bis.org/publ/regpubl.htm). That figure grew to $81 trillion by the end of March 2008 (source: BIS http://www.bis.org/publ/qtrpdf/r_qa0806.pdf#page=108)
in these derivatives, and clients such as hedge fund
s, commercial bank
s, government sponsored enterprises, etc. Products that are always traded over-the-counter
are swaps
, forward rate agreement
s, forward contract
s, credit derivative
s, etc. The total notional amount
of all the outstanding positions at the end of June 2004 stood at $220 trillion. (source: BIS: http://www.bis.org/publ/regpubl.htm). By the end of 2007 this figure had risen to $596 trillion and in 2009 it stood at $615 trillion. (source: BIS: http://www.bis.org/statistics/otcder/dt1920a.pdf)
US: Figures below are from SECOND QUARTER, 2008 http://www.occ.treas.gov/deriv/deriv.htm
http://www.occ.treas.gov/ftp/release/2008-115a.pdf
According to Bank for International Settlements
"$516 trillion at the end of June 2007"
Positions in the OTC derivatives market have increased at a rapid pace
since the last triennial survey was undertaken in 2004. Notional amounts
outstanding of such instruments totalled $516 trillion at the end of June 2007,
135% higher than the level recorded in the 2004 survey (Graph 4). This
corresponds to an annualised compound rate of growth of 33%, which is higher
than the approximatively 25% average annual rate of increase since positions
in OTC derivatives were first surveyed by the BIS in 1995. Notional amounts
outstanding provide useful information on the structure of the OTC derivatives
market but should not be interpreted as a measure of the riskiness of these
positions. Gross market values, which represent the cost of replacing all open
contracts at the prevailing market prices, have increased by 74% since 2004, to
$11 trillion at the end of June 2007. (page 28, http://www.bis.org/publ/qtrpdf/r_qt0712.pdf) http://www.bis.org/publ/qtrpdf/r_qt0712.pdf
The G-20’s proposals for financial markets reform all stress these points, and suggest:
Financial market
In economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...
for derivative
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
s, financial instruments like futures contracts or options, which are derived from other forms of assets.
The market can be divided into two, that for exchange-traded derivatives and that for over-the-counter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both.
Futures markets
Futures exchanges, such as Euronext.liffe and the Chicago Mercantile ExchangeChicago Mercantile Exchange
The Chicago Mercantile Exchange is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization...
, trade in standardized derivative contracts. These are options contracts
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
and futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s on a whole range of underlying
Underlying
In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the derivative depend on the value of this underlying...
products. The members of the exchange hold positions in these contracts with the exchange, who acts as central counterparty
Counterparty
A counterparty is a legal and financial term. It means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context....
. When one party goes long
Long (finance)
In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
(buys a futures contract), another goes short (sells). When a new contract is introduced, the total position in the contract is zero. Therefore, the sum of all the long positions must be equal to the sum of all the short positions. In other words, risk is transferred from one party to another. The total notional amount
Notional amount
The notional amount on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument...
of all the outstanding positions at the end of June 2004 stood at $53 trillion. (source: Bank for International Settlements
Bank for International Settlements
The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...
(BIS): http://www.bis.org/publ/regpubl.htm). That figure grew to $81 trillion by the end of March 2008 (source: BIS http://www.bis.org/publ/qtrpdf/r_qa0806.pdf#page=108)
Over-the-counter markets
Tailor-made derivatives not traded on a futures exchange are traded on over-the-counter markets, also known as the OTC market. These consist of investment banks who have traders who make marketsMarket maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
in these derivatives, and clients such as hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
s, commercial bank
Commercial bank
After the implementation of the Glass–Steagall Act, the U.S. Congress required that banks engage only in banking activities, whereas investment banks were limited to capital market activities. As the two no longer have to be under separate ownership under U.S...
s, government sponsored enterprises, etc. Products that are always traded over-the-counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
are swaps
Swap (finance)
In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
, forward rate agreement
Forward rate agreement
In finance, a forward rate agreement is a forward contract, an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used...
s, forward contract
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
s, credit derivative
Credit derivative
In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself...
s, etc. The total notional amount
Notional amount
The notional amount on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument...
of all the outstanding positions at the end of June 2004 stood at $220 trillion. (source: BIS: http://www.bis.org/publ/regpubl.htm). By the end of 2007 this figure had risen to $596 trillion and in 2009 it stood at $615 trillion. (source: BIS: http://www.bis.org/statistics/otcder/dt1920a.pdf)
Netting
Global:US: Figures below are from SECOND QUARTER, 2008 http://www.occ.treas.gov/deriv/deriv.htm
- Total derivatives (notional amount): $182.2 trillion (SECOND QUARTER, 2008)
- Interest rate contracts: $145.0 trillion (80%)
- Foreign exchange contracts: $18.2 trillion(10%)
- 2008 Second Quarter, banks reported trading revenues of $1.6 billion
- Total number of commercial banks holding derivatives: 975
http://www.occ.treas.gov/ftp/release/2008-115a.pdf
According to Bank for International Settlements
Bank for International Settlements
The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...
"$516 trillion at the end of June 2007"
Positions in the OTC derivatives market have increased at a rapid pace
since the last triennial survey was undertaken in 2004. Notional amounts
outstanding of such instruments totalled $516 trillion at the end of June 2007,
135% higher than the level recorded in the 2004 survey (Graph 4). This
corresponds to an annualised compound rate of growth of 33%, which is higher
than the approximatively 25% average annual rate of increase since positions
in OTC derivatives were first surveyed by the BIS in 1995. Notional amounts
outstanding provide useful information on the structure of the OTC derivatives
market but should not be interpreted as a measure of the riskiness of these
positions. Gross market values, which represent the cost of replacing all open
contracts at the prevailing market prices, have increased by 74% since 2004, to
$11 trillion at the end of June 2007. (page 28, http://www.bis.org/publ/qtrpdf/r_qt0712.pdf) http://www.bis.org/publ/qtrpdf/r_qt0712.pdf
Controversy about the financial crisis
The derivative markets have been accused lately for their alleged role in the financial crisis of 2007-2010. The leveraged operations are said to have generated an “irrational appeal” for risk taking, and the lack of clearing obligations also appeared as very damaging for the balance of the market.The G-20’s proposals for financial markets reform all stress these points, and suggest:
- higher capital standards
- stronger risk management
- international surveillance of financial firms' operations
- dynamic capital rules.
Further reading
- Weinberg, Ari, "The Great Derivatives Smackdown", ForbesForbesForbes is an American publishing and media company. Its flagship publication, the Forbes magazine, is published biweekly. Its primary competitors in the national business magazine category are Fortune, which is also published biweekly, and Business Week...
magazine, May 9, 2003. - European Central Bank (Editor: Tom Kokkola), "The Payment System", Frankfurt am Main 2010, Chapter 3, ISBN 978-92-899-0632-6.
External links
- PBSPublic Broadcasting ServiceThe Public Broadcasting Service is an American non-profit public broadcasting television network with 354 member TV stations in the United States which hold collective ownership. Its headquarters is in Arlington, Virginia....
(WGBHWGBH-TVWGBH-TV, channel 2, is a non-commercial educational public television station located in Boston, Massachusetts, USA. WGBH-TV is a member station of the Public Broadcasting Service , and produces more than two-thirds of PBS's national prime time television programming...
, Boston), "The Warning", Frontline TV public affairs program, October 20, 2009. "At the center of it all he finds Brooksley BornBrooksley BornBrooksley E. Born is an American attorney and former public official who, from August 26, 1996, to June 1, 1999, was chairperson of the Commodity Futures Trading Commission , the federal agency which oversees the futures and commodity options markets...
, who speaks for the first time on television about her failed campaign to regulate the secretive, multitrillion-dollar derivatives market whose crash helped trigger the financial collapse in the fall of 2008." - History and Types of Derivatives markets 1MTX Glossary