Trade Execution
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Trade Execution
What is a derivative?
A derivative is a financial instrument whose value is derived from some other asset or value (the underlying asset). Derivatives traders agree to exchange cash or assets over time based on the underlying asset’s value. Often, a small movement in the underlying asset can cause a large difference in the value of the derivative contract.
Investors tend to use derivatives in one of two ways. They use them to speculate and make a profit (if the underlying asset moves the way they expect) or as a hedge against one or more of their positions to mitigate any losses they might incur.
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 is largely unregulated.
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, which remains unclear.
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 is for a number of reasons, including the diverse nature of derivatives contracts, which de facto means that is 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 have become as successful a risk management tool as they are today.
What are the advantages of electronic trading?
By automating a majority of 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.
Which companies provide electronic trading platforms for OTC derivatives?
A small number of companies provide electronic markets for OTC derivatives, including
Tradeweb and
Bloomberg. Tradeweb introduced the first competitive electronic markets for interest rate and credit default swaps in 2005.
Legislation
Does proposed legislation mandate electronic trading?
What is the status of proposed legislation in the U.S. and Europe?
In the U.S.,
the bill approved by the House of Representatives and the Senate has been
signed into law by President Barack Obama on July 21, 2010. The Restoring American Financial Stability Act of 2010, which was developed by the Congressional Conference Committee, comprises the bills from House and the Senate into one piece of legislation. The bill aims to bring transparency and efficiency to the OTC derivatives industry.
Depending on how the new rules are written, the bill would grant regulators the power to seize and break up troubled financial firms whose collapse might cause widespread damage, it would set up a 10-member oversight council to monitor and address risks to the market’s financial stability and it would eliminate the Office of Thrift Supervision.
The bill also contains a number of provisions targeting the OTC derivatives industry, including the Volcker Rule, which would bar banks from trading with their own funds. The bill also requires most derivatives to be traded on
swap execution facilities (SEFs) or exchanges and be cleared through clearinghouses, and would require banks to spin off their OTC derivatives businesses into affiliates.
In Europe, The Committee of European Securities Regulators (CESR) has issued
two consultation papers designed to define certain terms in the new OTC derivatives landscape and asking for comments. The deadline for comment on the two reports, titled “Standardization and Exchange Trading of OTC Derivatives” and “Transaction Reporting on OTC Derivatives and Extension of the Scope of Transaction Reporting Obligations”, is August 16. the EU also has a timeline for actions it plans to take, including mandating CCP clearing of standardized derivatives and increasing the visibility of transaction reporting. The current timeline calls for an EU agreement to be reached in September. The European Commission, in a report published in October 2009, states that EC’s regulations will be largely consistent with those of the US and in line with the objectives outlined by the G20. The G20 leaders agreed that, “All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end 2012 at latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements”.
How has the UK responded to U.S. and pending EU OTC derivative legislation?
The
UK Financial Services Authority believes that standardized trades do not necessarily need to be executed on a central trading platform. It, along with the UK Treasury, has said that central clearing could lead to situations where a central counterparty is forced to clear a contract for which it cannot manage risk effectively. While the FSA agrees with the U.S. that increased standardization is a necessity, it does not agree that central clearing should be required. However, the EU plans to mandate central-counterparty clearing of standardized derivatives and increase the visibility of transaction reporting in 2010, so it is unclear whether the U.K.’s opinion will influence European financial policy as a whole.
How will this legislation affect derivatives markets? The financial regulatory overhaul bill signed into law would greatly affect the OTC derivatives marketplace. Almost all standardized swap transactions between dealers and major swap participants will have to be traded and cleared through a
Swap Execution Facility (SEF), an exchange or an electronic platform. In addition, customized swaps will have to be reported to central repositories.
The bill would also require banks getting federal financial aid to spin off their swaps operations into affiliates. The financial institutions can retain operations for interest-rate swaps, foreign exchange swaps, and gold and silver swaps, among others.
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.
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 (the OTC Derivatives Market Act of 2009) could mandate central clearing for all standardized OTC swap contracts.
Which companies provide central clearing for the derivatives markets?
How will new regulations affect the derivatives market?
The Restoring American Financial Stability Act of 2010 would effectively restructure the OTC derivatives market. All standardized swap transactions between dealers and major swap participants might 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 would be overseen by the CFTC and SEC, which would also oversee all OTC derivative transactions. In addition, all firms that trade OTC derivatives would be subject to federal supervision and regulation.
The Financial Services Authority (FSA) is the only regulator of derivatives in the UK.
For the other countries in Europe, 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 of Europe, as each country only has one regulatory agency, that agency oversees the entire market.