Derivatives 101

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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.

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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.

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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.

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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.

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Legislation

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

In the U.S., the bulk of these reform initiatives were embedded in the Dodd-Frank Act and implemented primarily by the Commodity Futures Trading Commission (CFTC), working in conjunction with the Securities Exchange Commission (SEC). In Europe, the regulatory landscape is a bit more fragmented as the majority of derivatives reforms are addressed in the Markets in Financial Instruments Directive (MiFID) and European Market Infrastructure Regulation (EMIR).

Most major derivatives reform deadlines have been met in the U.S., but the process of rule implementation and enforcement is still unfolding in Europe. However, starting on February 12, 2014 all European-based entities trading derivatives including IRS, CDS and equity derivatives were required to begin reporting their transactions to a trade repository under EMIR.

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Does proposed legislation mandate electronic trading?

The Dodd-Frank Act mandates that all routine derivatives be traded on Swap Execution Facilities (SEFs) or exchanges and be cleared through a clearinghouse.

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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.

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Clearing

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.

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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.

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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.

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Which companies provide central clearing for the derivatives markets?

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

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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 Conduct Authority (FSA) regulates the financial services industry in the UK. In Europe, each country has one national financial regulatory agency that regulates the market in that country, and ESMA contributes to the supervision of financial services firms with a pan-European reach.

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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.

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