Derivatives 101

Trade Execution

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

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Frequently Found Acronyms

Trade Execution

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.

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.

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.

 

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.

 

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.

 

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?
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”.