Derivatives 101

Trade Execution



Trade Execution

What is a derivative?

A derivative is a financial instrument whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. 

Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros.

Futures, forwards, options and swaps are all examples of derivative contracts.

How are derivatives traded?

There are two distinct types of derivatives; each is traded in its own way.

Exchange-traded derivatives are traded through a central exchange with publicly visible prices. Over-the-counter (OTC) derivatives are traded and negotiated between two parties without going through an exchange or other intermediaries. The market for OTC derivatives is significantly larger than for exchange-traded derivatives and was largely unregulated until 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, like hedge funds, and because there is no central exchange, traders are exposed to more counterparty risk. 

What is the definition of a “standardized” swap?

A swap is a type of derivative where two parties exchange financial instruments, such as interest rates or cash flows. There is still a lot of discussion on the definition of a standardized swap as it relates to central clearing.  The CFTC and SEC continue to refine rulemaking around swap definitions and clearing requirements.

Why are some derivatives traded over exchanges and others traded in Over-the-Counter markets?

There is active trading in Treasury and interest rate futures on exchanges, especially in Chicago. Aside from these standardized contracts, 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. Dealers play an important role in providing liquidity for what is an unlimited potential range of contracts. Without dealers’ willingness to risk capital when trading with large counterparties, such as insurance companies and pension funds, the derivatives markets would not trade as efficiently as they do.

What are the advantages of electronic trading?

By automating the execution process, electronic trading reduces commission prices and other human costs, which lowers overall cost-per-trade. Because electronic trading narrows spreads and increases liquidity, transparency and operational efficiency, it opens the market to more participants.



What is the status of proposed rulemaking in the U.S. and Europe?

Mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Commodity Futures Trading Commission (CFTC) is responsible for writing rules that will regulate the over-the-counter derivatives marketplace.

The CFTC has identified 32 areas where rules will be necessary and throughout the rule-making process has encouraged the public to provide input through open meetings and comment periods. 

As of June 2012, the CFTC has finalized 33 final rules and guidance and 7 final orders. Those rules can be found here. While the rule-making process remains ongoing, the CFTC has outlined final rules and interpretive orders it wishes to pursue in 2012, that list can be found here.

In Europe, an updated version of MiFID or the Markets in Financial Instruments Directive has been enacted in order to curb high-frequency trading and inject competition into exchanged-traded derivatives by introducing an accompanying regulation, MiFIR which will liberalize the clearing of instruments post-trade. MiFIR requires that OTC trading take place on a new trading platform known as an “organized trading facility” or an OTF.

MiFID also requires some non-EU firms who wish to conduct transactions with EU counterparties to register with European Securities Markets Authority (ESMA) while others would have to set up branches in the EU.  

Does proposed legislation mandate electronic trading? 

In the U.S., Restoring American Financial Stability Act of 2010 mandates that all routine derivatives be traded on Swap Execution Facilities (SEFs) or exchanges and be cleared through a clearinghouse.

What is the definition of a swap execution facility (SEF)?

The recently passed Dodd-Frank Act includes a requirement that any participant providing electronic markets for trading interest rate swaps will need to register as a Swap Execution Facility. A SEF is a facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce therefore allowing increased transparency and provides the tools for a complete trade audit.



What is central clearing?

Central clearing is the process in which financial transactions are cleared by a single (central) counterparty to reduce individual risk. Each party in the transaction enters into a contract with the central counterparty, so each party does not take on the risk of the other defaulting. In this way, the counterparty is essentially involved in two mutually opposing contracts.

What are the advantages of central clearing?

Central clearing of derivatives reduces counterparty risk and strengthens overall market integrity. It also helps with position segregation and portability in the event of a default, improves transparency for regulatory requirements and benefits the central management of trade lifecycle events, such as cash settlement with central counterparties and credit events in the CDS market.

Which transactions must be centrally cleared?

Currently, all exchange-traded and some OTC-traded derivatives contracts are centrally cleared. However, pending legislation central clearing will be required for most standardized OTC derivatives contracts.  However, in July of 2012, the CFTC unanimously approved an exemption from the requirement that derivatives trades go through regulated clearinghouses.  The exemption applies to “commercial end users,” such as industrial firms, utilities and airlines, which use swaps to counter risk in goods they purchase or manufacture and against fluctuations in interest rates.

Which companies provide central clearing for the derivatives markets?

LCH.Clearnet, the International Derivatives Clearing GroupCMEEurex and IntercontinentalExchange (ICE) are among those who provide derivative clearing services in the U.S. and Europe.


How will new regulations affect the derivatives market?

The Restoring American Financial Stability Act of 2010 will effectively restructure the OTC derivatives market. All standardized swap transactions between dealers and major swap participants will need to be traded on a Swap Execution Facility (SEF), an exchange or via an electronic platform and cleared through a central counterparty. These platforms will be overseen by the CFTC and SEC, which will also oversee all OTC derivative transactions. In addition, all firms that trade OTC derivatives would be subject to federal supervision and regulation.

Which government agencies in the U.S. and Europe are responsible for regulation? 

In the United States, the Securities and Exchange Commission (SEC),Commodity Futures Trading Commission (CFTC), and the Federal Reserve System (Fed), among others, are responsible for financial regulation.

The Financial Services Authority (FSA) is the only regulator of derivatives in the UK. For the other countries inEurope, each country has one national financial regulatory agency that regulates the market in that country.

Which portions of the market does each agency oversee?

The SEC regulates the securities industry (stocks, bonds, and security-based derivatives) and enforces its laws. The CFTC regulates the trading of agricultural commodities and futures, but as of recently, since most futures are now based on securities, the distinction between the organizations has been blurring, especially with regards to derivatives regulation.

In the UK and the rest ofEurope, as each country only has one regulatory agency, that agency oversees the entire market.