In the world of finance, you can buy assets or you can buy very valuable pieces of paper. Because buying and selling actual acres of crops, barrels of oil, or many other things for that matter, is not very practical, finance people have found a way around the problem by placing the value of an asset in a piece of paper. This is where derivatives come into play.
What is a derivative?
Derivatives are financial contracts between two parties that specify the conditions of purchase of an asset (including dates, amounts, description of asset, party obligations). The value of these contracts derives from the value of another asset, hence the name. The asset from which they get their value is called an underlying asset and it can take many forms: stocks, currencies, interest rates, commodities or even derivatives. When the price of the underlying asset changes, so does the value of the derivative.
What is the purpose of a derivative?
As prices fluctuate in time, so does the value of an asset. The three most common “things” that can fluctuate with an adverse effect on a company are foreign exchange risk, interest rate risk and commodity price risk. Financial derivatives take into consideration this notion of fluctuation over time and are used to lock in prices to mitigate any exposure to price volatility. They form part of two opposing investment strategies: hedging risk and speculating. Speculation, which involves trying to make profit on educated estimates of where a given market is headed for, plays a major role by contributing to market liquidity. Hedging, on the other hand, aims to protect a company’s finances from risks it may be exposed to. One of the most common corporate uses of derivatives is for hedging foreign exchange currency risk and there are several ways to do so.
Hedging involves investing in an asset with the intention of offsetting potential losses and mitigating risk. Its purpose is to contain a risk in order to limit and control its outcome. It implies using derivatives as an insurance policy to minimise exposure to risk. As an example, paying a car insurance hedges the risk of having to pay a large sum of money in case of a car accident. Hedging does not eliminate the risk in the underlying asset entirely, but it helps to transfer and reduce it.
Derivatives can be traded in two different ways. There are exchange-traded derivatives, or ETD, in other words, derivatives traded through specialised exchanges with publicly visible prices and there are derivatives traded without being listed on an asset exchange. In this case, they are called over-the-counter derivatives, or OTC derivatives. How do OTC derivatives work? They are private contracts traded directly between two parties without going through formal exchanges or the supervision of an exchange regulator. There are many types of derivative contracts, but we’ll address the four most common ones.
- Forward contracts and future contracts
These two types of derivative contracts fall within one same category. Forward contracts, or forwards, are to the OTC market what future contracts, or futures, are to the ETD market. In other words, forwards are not traded on a central exchange and futures are. In both cases, they are contracts signed between two parties to buy or sell an asset at a specified price, at a predetermined future date. By using forwards, companies can neutralise a risk and fix the price of the underlying asset that they will pay at a future date.
Options are generally traded on both the OTC market and the ETD market. They give the right, but not the obligation, to buy or sell a financial asset. There are two categories of options: put and call. Put options give the holder the right, but not the obligation, to sell an asset for a specific price and call options give the holder the right to purchase an asset before an established expiration date for a specific price. Like forwards, they enable the holder to protect themselves against price fluctuations but have the added advantage of letting the holder benefit from favourable price movements.
Lastly, the most common OTC derivative instruments are swaps. As their name suggests, swaps involve an exchange. They often concern financial instruments, like currencies and interest rates, that represent a risk due to their variable nature. Swaps are agreements according to which one party agrees to make fixed payments at an established frequency to another party that assumes the risk of paying the asset with the variable. The dates and calculations of the exchange are specified in the contract. Currency swaps and interest rate swaps are the two most common types of swaps.
Did you know? OTC derivatives played a major role in the 2008 financial recession. In fact, finance guru Warren Buffett dubbed derivatives “financial weapons of mass destruction” as early as 2002. Yet despite his slightly melodramatic description, he is known to use them. Given his strong words, we may wonder what kind of advantages and disadvantages OTC derivatives have.
- OTC derivatives are SME-friendly. Not all companies meet the capital requirements that are necessary to be registered on an exchange platform and OTC derivatives enabled small and unlisted companies to trade.
- OTC derivatives are flexible. OTC markets are free from the rigid rules and regulations of a formal exchange. Given that they are not subject to strict standardised norms like exchange-traded derivatives, they can be customised to meet the precise needs and requirements of the parties.
- OTC derivatives tend to be more confidential. As there are little disclosure requirements regarding pricing and contract terms, there can be more secrecy surrounding deals with OTC derivatives.
These advantages were particularly pronounced pre-2008. Since then, regulations have been imposed, notably with regard to confidentiality. Every coin has two sides and while OTC derivatives present some advantages, they too are not without any disadvantage.
Because OTC markets are by nature much less regulated than trading exchanges, parties to a contract face various types of risk that were particularly prevalent prior to the 2008 financial recession.
- OTC derivatives involve counterparty risk. Parties may refuse to honour the contract they concluded and default in their contract obligation. With fewer regulations in place, the suffering party had nobody to turn to and the defaulting party was not subject to penalties.
- OTC derivatives present liquidity risk. Again, due to lack of supervision and regulation, OTC derivatives may present the risk that a business does not have sufficient funds, either in terms of short-term cash flow or long-term funding, to meet its financial commitments on time. More broadly, OTC derivatives can lead to systemic risk.
- The OTC derivatives market is volatile. As the values of underlying assets can fluctuate rapidly, they may expose the parties to considerable losses.
In light of the various risks OTC derivatives can pose and their probability of occurrence, reigning in the market became a necessity. Figures speak for themselves: left unregulated, the OTC market peaked at $35 trillion at end-2008. Structural changes brought transparency and oversight in the OTC derivatives market and its value since regulations were introduced was estimated at a more reasonable $15.8 trillion at year-end 2020.
The regulation surrounding OTC derivatives
To improve the structure of the OTC derivatives market and counter possible future risks, the regulatory landscape of the market has evolved since the financial crisis of 2008. When it comes to regulation in the European Union, the European Market Infrastructure Regulation (EMIR) was put in place in 2012 to provide a framework to regulate OTC derivatives and to stabilise the market within EU Member States. It aims to establish common rules, and notably introduced:
- clearing obligations: EU companies that are counterparties to certain classes of OTC derivative contracts exceeding a certain threshold must now notify a central clearing party or central counterparty (CCP). A central clearing party is an entity that interposes itself between the two counterparties to a transaction. These entities must be approved by two authorities among which the ESMA (European Securities and Markets Authority). Non-EU companies are also subject to clearing obligations under certain conditions and notably if an impact on EU markets exists.
- reporting obligations: All eligible OTC derivatives must be reported to authorised trade repositories, (central data centres) which collect and maintain the records of derivatives transactions. The reports must outline each over-the-counter trade and contain specific standardised information including a legal entity identifier, a unique transaction identifier and information on the trading capacity of the counterparty.
- risk mitigation techniques: Over-the-counter derivatives transactions, and notably all those that are not centrally cleared, are subject to risk mitigation measures. Such measures include portfolio reconciliation and compression (in other words, making sure both parties interpret the terms in the same way, and replacing contracts with substantially similar transactions of decreased notional value to reduce volume and exposure), the timely confirmation of contracts and the implementation of a dispute resolution process among others.
Through the introduction of central clearing and the implementation of risk management standards, EMIR aims to reduce systemic, counterparty and operational risks and generally increases transparency in the OTC derivatives market.
EMIR is the European version of America’s Dodd Frank Act which was signed into law in 2010 in response to the 2008 recession. The question is, have these new rules and regulations improved the market?
OTC derivatives today
One lesson we have learned from the COVID-19 pandemic is that the regulatory reforms that were put in place some ten years ago to safeguard financial markets have borne fruit. Although the pandemic disrupted the world economy and brought financial markets across the world to a near-halt, global trading in derivatives remained altogether stable, despite some initial volatility. The regulatory reforms confirmed that the derivatives market is safer, more resilient, and more transparent today than it was in the past. With the disadvantages of OTC derivatives under better control, the market now presents even stronger advantages than it used to.