Chapter 1 - The Derivatives Market - Managing Derivatives Contracts - A Guide To Derivatives Market Structure, Contract Life Cycle, Operations, and Systems

11/13/2018 Chapter 1: The Derivatives Market - Managing Derivatives Contracts : A Guide to Derivatives Market Structure, Contract Life Cycle,
Structure, Contract Life Cycle, Operations, and Systems
 Managing Derivatives Contracts : A Guide to Derivatives Market Structure, Contract Life Cycle, Operations, and Systems
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P REV N EXT
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Part 1 The Big Picture
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Chapter 2: The Derivative Products
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CHAPT ER RESET
1
The Deriv ativ es Market
Deriv ativ es play a v ital role in today ’s global economy .

They are powerful and v ersatile tools. Deriv ativ es enable
financial institutions, large corporations, and high-net-
worth indiv iduals to manage their ex posure to financial
risk in its manifold forms. The global deriv ativ es market
operates seamlessly around the clock, trading a constantly
mutating v ariety of complex instruments on rapidly
changing technology platforms.
The pace and direction of these changes hav e been

hastened and shaped by the financial crisis of 2008 and its
recessionary aftermath. These ev ents ex posed sy stemic
shortcomings and catastrophic perils in the deriv ativ es
market and antagonized public perception of it. The
phasing in of root-and-branch regulatory reform of the
deriv ativ es market has prompted transformativ e
adaptations in deriv ativ e instruments, technology ⬆
platforms, and the management and operation of the whole
deriv ativ es contract life cy cle.
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11/13/2018 Chapter 1: The Derivatives Market - Managing Derivatives Contracts : A Guide to Derivatives Market Structure, Contract Life Cycle, Operations, and Systems
Unlike most books on deriv ativ es, which deal with the
mathematical techniques and models of risk management,
this book focuses on what nonquantitativ e deriv ativ es
professionals need to know about the end-to-end
deriv ativ es life cy cle. It shows such professionals, who
outnumber the cadre of quants by an order of magnitude in
the ty pical deriv ativ es organization, how to adjust -
successfully to the new and emerging product, technology ,
and regulatory conditions of the post-2008 deriv ativ es
market.
The objectiv es of this foundation chapter are briefly to
define the financial deriv ativ e
outline the structure and size of the deriv ativ es market

and its submarkets
set out the need for deriv ativ es and their benefits to the
economy and capital markets
ex plore the sy stemic dangers and risks of deriv ativ es
surv ey the ongoing regulatory changes in the

deriv ativ es market
identify the operational and technical challenges of

managing deriv ativ e contracts in the emerging new
regulatory landscape
discuss the importance of information technology in

each area of deriv ativ es contract management
Financial Deriv ativ es
A derivative is an instrument deriv ed from at least one

other elementary instrument known as the underlying; the
v alue of a deriv ativ e instrument depends on the v alue of
the underly ing. Ex amples of underly ings include stocks,
bonds, ex change rates, interest rates, credit
characteristics, indices, commodities, and other deriv ativ e
instruments.
⬆
From a practical standpoint, the deriv ativ es contract is
simply an agreement between two parties, and its
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name derivative. An ex ample of a deriv ativ e is an option

contract on a stock issued by some corporation, in which
the v alue of the option is deriv ed from the performance of
the stock. Another ex ample of a deriv ativ e is an interest
rate sw ap, whose v alue is deriv ed from the underly ing
interest rate index on which it is based.
Deriv ativ es can be div ided into two major categories:

financial derivatives and commodity derivatives.
Financial deriv ativ es are deriv ed from financial
instruments such as stocks, bonds, interest rates, and
currency rates. Commodity deriv ativ es, on the other hand,
are deriv ed from underly ing commodities such as precious
metals, agricultural products, and commodity indices. This
book is concerned only with financial deriv ativ es. The term
derivatives and its v arious sy nony ms—financial derivative
instruments, derivative contracts, contracts, derivative
products, and derivative instruments—should be
understood throughout this book to refer to financial
derivatives.
Deriv ativ e instruments are distinguished from other

financial instruments by the following characteristics:
Life span. Unlike a securities transaction (stock or

bond) that is settled at once, a deriv ativ es contract
starts on a certain date and stay s in effect until some
later date with one or multiple settlements during that
period. The life span of a deriv ativ es contract may v ary
from a few weeks to many y ears.
Settlem ent. Deriv ativ e contracts are settled either

financially (cash-settled) or through phy sical deliv ery
(delivery-settled). Most deriv ativ e contracts are cash-
settled regardless of the underly ing. This enables
participants to trade v arious ty pes of deriv ativ es
without owning the underly ing assets. Howev er, a
small proportion of deriv ativ e contracts are phy sically
settled by deliv ering the actual underly ing assets. ⬆
Contract terms specify method of settlement and
eligible assets that can be deliv ered in case of phy sical
deliv ery .
Inv estm ent. Deriv ativ es—ev en those with large

notional value (the nominal or face amount of
contract)—ty pically require only a nominal inv estment
such as an initial margin, whereas securities (such as
stocks, loans, and bonds) transactions require upfront
inv estment.
Positions. Technically , market participants do not

buy or sell deriv ativ es in the same way that they
transact other financial instruments. Rather, they enter
into (open) and terminate (close) deriv ativ es positions.
During the contract term, most deriv ativ e contracts
are v alued using market prices; others are v alued using
mathematical models. Deriv ativ e contracts are often
managed on a portfolio basis, combined with other
assets or deriv ativ es.
Credit risk. The credit risk inv olv ed in deriv ativ e

transactions is different from the credit risk carried by
other financial instruments. For ex ample, with a loan,
the amount at risk is the principal paid to the borrower.
The credit risk is unilateral, meaning that only the
lender is ex posed to risk from the borrower. In
contrast, the credit ex posure in most deriv ativ e
transactions is bilateral. Because the v alue of a
deriv ativ e may swing to either side, each party
inv olv ed may be ex posed to risk at v arious points ov er
the life of the contract.
Cash-flow direction. During the term of most

deriv ativ e contracts, two-way cash flows are common.
Most other financial instruments hav e only one-way
cash flows.
Risk ex posure. Deriv ativ es enable participants to

trade risk ex posure from an underly ing asset without
actually owning that asset.
Position m anagem ent. The risk of holding a

deriv ativ es contract may be dissimilar to the risk of
holding its underly ing. For instance, the risk inv olv ed ⬆
in purchasing a bond is not necessarily the same as the
risk inv olv ed in purchasing a deriv ativ es contract on
that same bond. As a result, managing deriv ativ e
positions is quite different from managing the position

in the underly ing.
The Deriv ativ es Market Structure
The deriv ativ es market is broadly div ided into two

submarkets: the listed market and the over-the-counter
(OTC) market. These submarkets are differentiated by their
products and their regulatory and operational
requirements, as depicted schematically in Figure 1 -1 and
described in the following sections.
Fi gure 1-1. Derivatives market segments
T he Listed Market
The listed market consists of standardized contracts traded

on ex changes. A derivatives exchange is a regulated entity
that prov ides a trading facility to its members. The
deriv ativ e products on the ex change are standardized with
specific deliv ery and settlement terms. Today ’s deriv ativ es
ex changes trade a wide v ariety of contracts, ranging from
simple stock options to interest rate swaps. As financial
instruments ev olv e, ex changes continue to introduce -
⬆
v ariety of products.
The listed market is also called the exchange market, the

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The products
traded on the listed market are v ariously called listed

derivatives, listed contracts, on-exchange derivatives, or
standardized derivatives.
Traditionally , trading on ex changes took place on a

phy sical trading floor through a face-to-face auction
process. Today , most deriv ativ es ex changes hav e replaced
or supplemented their floor-based trading with electronic
trading.
Trading on ex changes is limited to standard contracts. All

listed products are cleared by a designated clearinghouse,
which guarantees the fulfillment of contractual obligations.
Central clearing v irtually remov es the credit risk from
listed contracts. Since these contracts traded on
ex changes, they prov ide higher liquidity .
The major benefits of listed markets are the following:
The obligations of listed contracts are guaranteed by

the clearinghouse. As the central counterparty (CCP)
to a listed contract, the clearinghouse eliminates
counterparty credit risk.
All contracts are highly standardized in nature. For

instance, the ex piration date, underly ing entity ,
settlement sty le, and all other key attributes of
contracts are predefined by the ex change. Hence, the
ex change market is efficient and prov ides multilateral
trading and substantial liquidity .
Ex change trading leads to lower transaction costs.
Clearinghouse and clearing members use a margining

process to manage the risk. All positions are marked-
to-market on a daily basis (sometimes ev en more than
once a day ). This v irtually eliminates counterparty
risk.
Ex change-traded deriv ativ es hav e greater price

transparency because all trading prices are publicly ⬆
av ailable.
Despite the many benefits of the listed market, listed

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e the fundamental
needs of those trading deriv ativ es. Listed contracts may

not serv e all the risk management needs of a portfolio in
terms of duration and quantity . In addition, in certain
situations, it may be more ex pensiv e to hedge the risks that
ex ist in a portfolio using listed contracts. The nex t section
ex plains how the OTC market fulfills certain needs that are
not adequately met in the listed market.
T he Ov er-the-Counter Market
Over-the-counter (OTC) is a term used to describe trading

activ ity that does not take place on a regulated ex change.
In the OTC market, contracts are negotiated (traded) in
different way s. The OTC market div ides into two parts: the
bilateral OTC market and the cleared OTC market.
The Bilateral OTC Market
In the bilateral OTC market, trading takes place directly

between two parties with terms designed to suit the needs
of the contract seeker. Trading in OTC markets takes place
ov er traditional channels including telephone, email,
electronic, and proprietary dealer trading platforms.
Bilateral contracts—also known as negotiated,

nonstandard, unlisted, or bespoke contracts—are not
cleared through any clearinghouse. Both parties remain as
counterparties to each other until the termination of the
contract. Ty pically , these contracts are traded between
institutional clients and inv estment banks (broker-dealers)
and may be customized to address any specific ex posure
(underly ing, contract size, maturity , embedded options,
and so on) of the institutional client.
In principle, bilateral contracts can be formed in an

unlimited number of way s because each one can be
customized. As a result, bilateral markets trade a broader
range of contracts than the listed markets. Howev er,
bilateral OTC contracts carry credit risk and the risk of the
⬆
counterparty defaulting on its obligations.
The Cleared OTC Market

In recent y ears, OTC markets hav e introduced cleared OTC

contracts (also known as cleared contracts), which are
standardized and cleared through a CCP. These contracts
are quite similar to listed contracts in that both parties in
the trade use a clearinghouse as the counterparty
guaranteeing the fulfillment of obligations of these
contracts. As a result of Dodd-Frank regulations that
mandate the clearing of certain OTC contracts (see Chapter
9), many electronic trading platforms and CCPs hav e
ev olv ed to clear a wide range of OTC contracts.
Market Venues
Deriv ativ es trading takes place in sev eral major v enue

ty pes:
Ex changes. Orders from buy ers and sellers are

matched using open outcry auctions or electronic
order matching sy stems.
Dealer m arket. Dealers either act as counterparties

to trades or broker (arrange) trades between
customers.
Electronic trading platform s. Electronic trading

platforms (ETPs) are computerized sy stems that bring
multiple customers and dealers together and
accommodate ex ecution electronically , either
automatically or through negotiation ov er the
electronic channel. ETPs promote low transaction
costs and multilateral trading (multiple market-maker
bids and offers). There are two major classes of ETPs:
regulated ETPs—such as sw ap execution facilities
(SEFs) and multilateral trading facilities (MTFs)—and
unregulated ETPs—such as those run by dealers and
other firms.
Interdealer broker. This v enue is a market in which

only dealers can participate. Dealers trade with each
other using both dedicated electronic platforms as well
⬆
as traditional bilateral channels.
Market Size
There is no perfect or univ ersal method for measuring the

size of the deriv ativ es market. Commonly used measures
are notional, exposure (at-risk capital), and amount of
money spent (cost of transactions). The notional measure
has been widely used until recently , but it suffers from the
deficiency that the actual v alue of ex change of assets or
cash resulting from these contracts does not in general
correspond to their notional v alue. As a result, the gross
market value (also known as exposure or at-risk capital)
measure—representing the cost of replacing all outstanding
contracts at current market price—is increasingly used.
Different organizations track different aspects of the size of
the ov erall deriv ativ es market. For ex ample, the Bank for
International Settlements (BIS) reports the total global
notional amounts of the deriv ativ es market, whereas the
International Swaps and Deriv ativ es Association (ISDA)
reports the transaction v olumes in OTC markets. Similarly ,
local agencies report on deriv ativ e markets by sector: for
instance, the US Office of the Comptroller of the Currency
reports the deriv ativ es v olume by all banks, and the
National Association of Insurance Commissioners reports
the deriv ativ es v olume by the insurance industry .
According to a June 201 3 surv ey by BIS, the outstanding

notional of global OTC deriv ativ es was $693 trillion, and
1
their gross market v alue was $20 trillion; while the
outstanding notional of global ex change-traded deriv ativ es

2
was around $68 trillion.
Market Play ers
The deriv ativ es market is predominantly a professional

wholesale market whose main participants are classified as
banks, inv estment firms, insurance companies, and
corporations. Figure 1 -2 shows v arious play ers in the
deriv ativ es market in the contex t of the market structure.
Fi gure 1-2. Derivatives market structure and players
The following list details the categories of market play ers

that can be found in the deriv ativ es market. The v arious
play ers’ roles are ex plained in detail in Chapter 5.
Buy -side firm s. Buy-side firms are also known as

institutional investors or end users. They include
hedge funds, priv ate clients, banks, loan portfolio
managers, insurance firms, asset managers, corporate
treasurers, arbitrageurs, speculators, and scalpers (day
traders).
Sell-side firm s. Sell-side firms are also known as

broker-dealers, or simply dealers. They include all
ty pes of brokerage firms, including market makers,
ex ecution brokers, and clearing brokers (futures
commission merchants).
T rading v enues. Trade ex ecution v enues include

deriv ativ es ex changes and v arious ty pes of electronic
trading platforms such as SEFs, dealer platforms, and
interdealer platforms.
Clearing firm s. Institutions that clear trades and

serv e counter party to both sides of the original trade
⬆
as central counterparties (CCPs) are clearing firms,
also known as clearinghouses.
Serv ice prov iders. Institutions that prov ide v arious

ty pes of serv ices include affirmation platforms,
custodians, banks, pay ment processing institutions,
data v endors, and transaction processing firms.
Regulatory and m arket associations. V arious

gov ernmental and nongov ernmental organizations
regulate, monitor, and assist ov erall market function.
Note Although many retail customers participate in

deriv ativ es trading, they trade listed products through
retail brokerage firms. The retail market is highly
automated and standardized, which keeps transaction costs
low. Retail brokers prov ide all the tools needed for trading
and other activ ities. Retail trading and related topics are
outside the scope of this book.
Adv antages of Deriv ativ es
The financial markets perform a number of v ital functions.

The securities markets, for ex ample, help promote trade,
prov ide a v enue for businesses to raise capital, and giv e
opportunities for those who own capital to make a return
on their money through inv esting. The deriv ativ es market
play s an important role in the global economy by enabling
market participants to transfer risk, prov iding price
discov ery , promoting efficient markets, and lowering
transaction costs.
Chapter 2 surv ey s the v arious ty pes of deriv ativ es and

their respectiv e uses, but a detailed description of uses is
outside the purv iew of this book. The following list
highlights some of the beneficial roles deriv ativ es play in
the financial markets:
Hedging against risk: Corporations, financial

institutions, and other market participants use
deriv ativ es to manage (hedge) risks such as market risk
stemming from such fluctuating factors as the price of
⬆
raw materials, ex change rates, and interest rates.
Speculation. Deriv ativ es allow inv estors to take

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enable inv estors to profit either from correctly

anticipating changes in the prices of assets or interest
rates or from accurately predicting when credit ev ents
will occur. As a result, speculation promotes price
discov ery and efficient markets. Speculators
deliberately take on the risks related to changes in
prices and other market parameters for the purpose of
deriv ing profit. They also contribute to the liquidity in
the market.
Alternativ e inv estm ent opportunities.

Deriv ativ es prov ide an alternativ e to inv esting directly
in assets such as stocks and bonds. They lower
transaction costs while prov iding the risk and reward
that are inherent to direct inv estment, thereby helping
to preserv e capital.
Risk trading. Deriv ativ es such as credit contracts

separate the credit risk component from inv estment,
allowing institutions to transfer or trade just the risk.
Cash-flow m anagem ent. Deriv ativ es allow

inv estors to change the nature of an inv estment
without incurring the costs of actually replacing or
trading the portfolio asset in question. In addition,
deriv ativ es allow firms to create pay off patterns that
are compatible with their strategy and degree of risk
av ersion at a lower cost.
Price discov ery . Asset prices depend on market

conditions that affect the supply and demand. Futures
contract prices in the deriv ativ es market reflect these
market conditions. The futures contract price is used in
the discov ery of the current (spot) price of the
underly ing asset.
Prom otion of adv anced strategies. The use of

deriv ativ es allows market participants to dev elop
adv anced strategies to manage risk and improv e the
performance of their portfolios.
⬆
Cost efficiency . Deriv ativ es are cost-efficient insofar
as they reduce ex penses when creating portfolios with
specific parameters and enhance the liquidity and price
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Better protection. Ongoing ex pansion of cleared OTC

products offers the best of both worlds: the contract
v ariety of the OTC market and the lowered
counterparty risk of the listed market.
Despite all of their adv antages, deriv ativ es contracts come

with risks of their own. Collectiv ely , deriv ativ es may
increase sy stemic risk in the financial markets, which is
part of the reason why they hav e drawn widespread -
criticism in recent y ears. The “Dangers and Challenges of
Deriv ativ es” section discusses some of the drawbacks of
deriv ativ es.
Adv antages of OT C Deriv ativ es
The prev ious section identified the benefits of deriv ativ es

and noted that these financial instruments hav e drawn
harsh criticism for the risks they present not only to their
users but also to the global financial sy stem. This section
ex plains why OTC deriv ativ es in particular are necessary
despite their inherent dangers.
The fundamental purpose of deriv ativ es contracts is to

manage risk. Risk ex posure can arise in v arious way s, and it
is not possible to design and trade standardized deriv ativ es
that address all possible forms of risk ex posure. It is
important for the inv estor to find the right deriv ativ e—
preferably a single contract that cov ers almost all of the
risk ex posure at the least ex pense. OTC deriv ativ es offer a
solution that fills this need.
The OTC market prov ides such adv antages as product

flex ibility , market liquidity , legal certainty , standard credit
risk management support, confidentiality , and a large
dealer network, elaborated as follows:
Custom products and cost. OTC contracts can be

designed to manage any risk, whether that inv olv es
interest rates, inflation, or credit for any duration. As a
result, ov erall transaction costs are less than for
⬆
multiple standard contracts.
Dealer network, liquidity , and com petitiv e

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a large dealer
network, and these dealers play a critical role by

assuming ex posure for the risks that market
participants want to transfer. Dealers also prov ide
needed liquidity by taking the opposite position in
client trades. The ex istence of a large network of
dealers across the globe promotes competitiv e pricing
in the OTC market.
Legal certainty and credit risk m anagem ent.

OTC markets hav e fix ed many shortcomings by
introducing standard contract terms as well as
processes to improv e the legal certainty of contracts
and manage counterparty credit risk. OTC markets
hav e resulted in the creation of legal frameworks and
risk management tools, such as netting and the use of
collateral.
T ransaction confidentiality and anony m ity .

OTC deriv ativ es contracts are confidential agreements
between two counterparties. This confidentiality
prov ides great protection for participants in the OTC
market, and it also protects their business strategies.
Howev er, recent regulations hav e introduced certain
transparency measures while maintaining the
confidentiality inherent to the OTC market.
New products. Due to the flex ibility and heav y

inv olv ement of dealers, the OTC market works as an
incubator for new financial products.
Dangers and Challenges of Deriv ativ es
The financial crisis of 2008 and the consequent Great

Recession prov oked a furious backlash against OTC
deriv ativ e instruments. Although some of this criticism
may be misplaced, deriv ativ es undeniably present multiple
and potentially catastrophic risks to the financial sy stem.
They can cause sharp changes in the v alue of underly ing
assets, lack transparency , enable speculativ e bets that fail,
and be inappropriately marketed. When these
⬆
v ulnerabilities are actualized on a large scale, deriv ativ es
can dangerously destabilize the entire financial sy stem,
especially when major participants fail (see the nex t
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Dangers and challenges of deriv ativ es include the

following:
Com plex ity . Many deriv ativ es are highly complex

and opaque, ex posing inv estors to irresponsible
marketing and insufficient understanding of the
products.
High lev els of ex posure. Many deriv ativ e products

hav e the potential for large financial losses. If these
instruments are used for speculativ e purposes or
without a full understanding, they may cause serious
losses.
Com plex risk m easures. Although deriv ativ es are

used to manage the risk, a deriv ativ es contract itself
can also create risk ex posure. Failure to effectiv ely
assess and hedge that ex posure may lead to major
losses.
Com plicated hedging strategies. Some market

participants hav e resorted to the use of complicated
hedging strategies with deriv ativ es. If these strategies
do not succeed, they may result in major losses.
Sy stem ic risk. Some OTC market participants use too

much lev erage, which can create great sy stemic risk. In
addition, lack of transparency may increase the risk in
multiple folds.
Large size. The notional amount of outstanding

positions in the global deriv ativ es market is quite large.
Problems in any part may result in a major impact on
the total global financial sy stem.
Regulatory com plex ities. Due to a lack of

transparency and the complex ity of products, it is hard
to efficiently regulate and superv ise the deriv ativ es
market. Howev er, new regulations are designed to
address transparency issues.
Price discov ery challenges. Lack of transparency

⬆
and uniformity in the bilateral OTC market make price
discov ery more challenging than for ex change-traded
instruments.
High-Profile Failures
Ov er the past two decades, deriv ativ es hav e been

implicated in a numerous high-profile corporate failures
that had significant impacts on the global financial markets,
such as the following:
AIG. After the asset markets collapsed in 2008, AIG

was ex posed to a large number of deriv ativ es positions
that brought the company to the brink of collapse. The
US gov ernment interv ened and rescued AIG with
massiv e loans.
Lehm an Brothers. In 2008, Lehman Brothers—a

major counterparty (dealer) in the OTC deriv ativ es
market—defaulted, creating a major sy stemic risk. The
ev entual collapse of Lehman Brothers led to a default
on obligations that ex isted under OTC deriv ativ es
contracts, among others.
Enron. In 2001 , Enron filed for bankruptcy . Enron

was holding deriv ativ e contracts based on the prices of
oil, gas, and electricity . These transactions were largely
unregulated and had no reporting requirements.
Speculativ e deriv ativ es losses concealed by fraud
ev entually led to the collapse of Enron.
Long-T erm Capital Managem ent (LT CM). In

1 998, LTCM, a high-profile hedge fund, incurred
massiv e losses when their strategies failed amid the
East Asian financial crisis and the Russian bond default.
The failure of the hedge fund’s deriv ativ es strategies
caused the firm ev entually to collapse.
Orange County . In 1 994, Orange County , California,

was forced into bankruptcy when ex posure of its
deriv ativ es positions to rising interest rates resulted in
major losses.
The sy stemic effects of major failures such as these led to

the introduction of new regulations and restructuring of
the deriv ativ es market, surv ey ed in the nex t section.
⬆
The Changing Regulatory Landscape of Deriv ativ es Market
Since its inception, the deriv ativ es market has undergone

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the wake of the 2008 financial crisis, gov ernments around

the world hav e been introducing new regulations to
mitigate the dangers and challenges posed to their
economies by the deriv ativ es markets.
Listed deriv ativ e markets are regulated by national

gov ernment agencies—such as the US Commodity Futures
Trading Commission (CFTC) and US Securities and
Ex change Commission (SEC), discussed in Chapter 5—
international regulatory organizations, and industry
associations. Listed markets hav e been around for some
time and, as a result, they are well regulated within sound
risk-management frameworks. In addition to the market
regulations, each ex change and clearinghouse maintains its
own set of rules to help promote strong and healthy
markets.
The big challenge arises in OTC markets. As discussed in the

two preceding sections, complex ity and lack of
transparency in the OTC market hav e been widely blamed
for ex cessiv e sy stemic risk, market abuse and
manipulation, and catastrophic failure. To mitigate risk and
check abuses, regulators need transparency .
Post-2008 regulations of OTC markets notably include Title

V II of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the Dodd-Frank Act) in the United States
and European Markets Infrastructure Regulation (EMIR)
in Europe. These regulations focus on ov ersight of OTC
markets with the goal of giv ing regulators actionable
insight into market participants’ trading activ ities and risk
ex posures by affording greater transparency and better
tools for reining sy stemic risk.
These new regulations phase in the following key changes

to OTC markets:
Certain OTC contracts—namely , cleared OTC contracts,

or sw aps—are standardized. ⬆
Electronic trading platforms—namely , MTFs and SEFs—
are established.
All standardized OTC contracts must be ex ecuted on

regulated ex changes or SEFs or MTFs and cleared
through a CCP.
Each counterparty must post collateral, as required by

the CCP.
All OTC deriv ativ e transactions (both cleared and

noncleared) are subject to regulatory ov ersight.
Central trade repositories—sw ap data repositories

(SDRs)—are established for the purposes of recording
market transactions and prov iding required reports to
regulators and limited information to the public.
These regulatory reforms are fostering rapid growth in the

cleared OTC market. Chapter 9 ex plains them in detail.
Importance of Information Technology
Today ’s financial markets could not accommodate their

staggering market v olume, complex business models,
my riad regulatory requirements, millions of market
participants, and the v arious functions without their
information technology (IT) infrastructures. Only well-
designed and well-built IT platforms can deliv er the
required performances, accommodate the required
v olumes, and comply with regulatory requirements.
In particular, technology has fueled continuous innov ation

in the deriv ativ es market. Because deriv ativ es are the most
complex ty pe of financial instruments, they rely more than
any other ty pe on technological infrastructures throughout
their life cy cle. The role technology play s in the deriv ativ es
supply chain is outlined as follows and cov ered in depth in
Part IV of this book:
Structuring and pricing. The structuring and

pricing of most complex products relies heav ily on the
use of computer models. Accurate implementation and
timely ex ecution are crucial to the successful use of ⬆
these instruments by businesses.
Electronic trading. Trading in listed markets is done

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er electronic platforms. Ev en pit today.
trading See pricing options.
relies on sy stems that deliv er data and allow traders to

stay on par with the electronic side of the trading. OTC
trades are increasingly being ex ecuted on electronic
platforms, too. The impetus of the mov ement of the
deriv ativ es market to electronic trading is ineluctable.
Post-trade processing and straight-through

processing. In listed markets, end-to-end trade
processing is fully automated by straight-through
processing (STP) and runs on most adv anced IT
infrastructures built by ex changes and clearinghouses.
In OTC markets, many third-party serv ice prov iders
are hosting post-trade and middle-office serv ices.
Demand for these serv ices has been growing in
response to regulatory reform. Owing to the
complex ity of these operations, many small and
midsize firms hav e been mov ing to these serv ice
prov iders. To keep costs down, serv ice prov iders rely
on technologically adv anced sy stems. Automation
helps to reduce transaction costs.
Central clearing. Central clearing is the backbone of

stable markets. Timely processing of collateral is the
key to the successful risk management of
clearinghouses. IT infrastructure play s a major role in
processing daily transactions and maintaining
collateral both at clearinghouses and clearing brokers.
Settlem ents. In today ’s markets, most of the

settlement process is done electronically . Most end
clients, custodians, and banks are electronically
connected, and their settlement processes are
automated.
Contract m anagem ent. The most important part of

managing the deriv ativ es contract is making sure that
it serv es its original purpose throughout its life cy cle
while managing the risks associated with holding a
specified deriv ativ es position. Contract management
requires continuous v aluation, calculation of profit and
⬆
loss and risk analy tics, collateral management,
simulations, and stress testing. The results of all these
processes rely heav ily on underly ing models, which in
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infrastructure.
Regulatory ov ersight. Regulations demand

intensiv e and timely reporting of market activ ity . The
trade repositories and clearinghouses maintain
transaction warehouses in order to comply with the
reporting requirements established by regulations.
These warehouses cannot function without adv anced
technological platforms.
Marketwide connectiv ity . The deriv ativ es market

has adopted a wide range of standards and protocols—
including FpML, FIX, and SWIFT (Chapters 1 8 and 1 9)—
to achiev e univ ersal connectiv ity . The market cannot
operate without the proper infrastructure to enable
message processing and connectiv ity .
T im ely data deliv ery . Trading, collateral

management, and other activ ities rely on timely and
accurate data. Today a v ery large v olume of data is
transmitted efficiently among market participants. The
requisite speed, accuracy , and v olume are impossible
to attain without modern IT infrastructure.
Operational and Technological Challenges
In addition to the dangers of deriv ativ es already

considered are the following operational and technical
challenges that can arise when dealing with deriv ativ es
contracts, detailed in Part IV of this book:
Post-trade processing issues. Timeliness and

accuracy are crucial for successful order processing.
Although most operations are automated, there are
still certain areas that are in part manually done owing
to the complex ity of the products inv olv ed. Because
any manual inv olv ement increases the operational risk
inv olv ed, it is critical to employ automation as much as
possible.
Collateral m anagem ent. This is an important

counterparty risk management tool. Sy stems and
models must be accurate, and underly ing data must be ⬆
accurate and timely to generate collateral reports.
Producing the least number of mismatches is a key
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Autom ation. The automation of electronic

communication and transaction processing among all
market play ers is essential to speed and cost efficiency .
Marketwide STP is complicated by the many different
ty pes of institutions inv olv ed, each running on
different technology platforms. The widespread
adoption of standardized protocols such as SWIFT,
FIX, and FpML helps in addressing these challenges.
Still, many firms are struggling to catch up with
adv ances in this area.
Contract workflow autom ation. To mitigate

operational risk, firms must adopt a robust and
comprehensiv e workflow while supporting end-to-end
automation to achiev e STP.
Reconciliations. Firms must employ knowledgeable

personnel who can resolv e issues and mismatches
promptly to reduce operations and financial risk and
av oid any compliance v iolations.
Costly infrastructure and resources. Deriv ativ es

processing demands more powerful and sophisticated
IT infrastructure. In addition, people with deriv ativ es
ex pertise are in high demand.
Electronic connectiv ity . Maintaining the electronic

connectiv ity with v arious serv icing institutions is
critical in achiev ing STP.
Large operational risks. As a result of complex

processes and manual operations, firms are ex posed to
substantial operational risk.
Nonstandard OT C m arket operations. To manage

OTC positions, each participant must own (by v irtue of
building or buy ing) technology infrastructure.
Dev eloping this infrastructure requires ex pensiv e
ex pertise in areas such as accounting, v aluation
models, collateral processes, portfolio reconciliations,
and deriv ativ es analy tics.
⬆
Summary
This chapter outlines the deriv ativ es market. Deriv ativ e

Find answers on theinstruments
are used to manage new.
risk exSubscribe
posure by today. See pricing options.
prudently mitigating it or speculativ ely ex ploiting it.
There are three major market segments: listed markets, in

which standardized products are traded in a highly
controlled and safe ex change env ironment; traditional OTC
bilateral markets, in which both parties directly enter into
the contract; and OTC cleared markets, in which certain
OTC products are traded on a registered trading v enue and
cleared through a clearinghouse. Most of the deriv ativ es
market is driv en by large financial and non-financial
institutions.
In spite of heav y criticism in the wake of the 2008 financial

crisis, deriv ativ es continue to play a major role in today ’s
financial and nonfinancial markets for risk management.
Regulatory reform aims to improv e market transparency ,
to control fraud and abuses, and to codify strong financial
risk and operational risk management practices that will
preserv e the v alue of deriv ativ es as incredibly powerful
financial instruments. This chapter looked in particular at
how regulatory reform is transforming the OTC market.
Ex cept where otherwise indicated, each of the topics

touched on in this chapter will be treated at length in
subsequent chapters. The nex t chapter delv es into the
v arious ty pes of deriv ativ es instruments.
______________________
1
Bank for International Settlements, “OTC Deriv ativ es
Statistics at End-June 201 3,”

www.bis.org/publ/otc_hy1311.pdf
(http://www.bis.org/publ/otc_hy1311.pdf), Nov ember 201 3.
2
Bank for International Settlements, “Deriv ativ es Traded
on Organized Ex changes,”
http://www.bis.org/statistics/r_qa1312_hanx23a.pdf
(http://www.bis.org/statistics/r_qa1312_hanx23a.pdf), ⬆
Nov ember 201 3.
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Part 1 The Big Picture Chapter 2: The Derivative Products

Chapter 1 - The Derivatives Market - Managing Derivatives Contracts - A Guide To Derivatives Market Structure, Contract Life Cycle, Operations, and Systems

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Chapter 1 - The Derivatives Market - Managing Derivatives Contracts - A Guide To Derivatives Market Structure, Contract Life Cycle, Operations, and Systems

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Structure, Contract Life Cycle, Operations, and Systems

Deriv ativ es play a v ital role in today ’s global economy .

The pace and direction of these changes hav e been

The objectiv es of this foundation chapter are briefly to

define the financial deriv ativ e

outline the structure and size of the deriv ativ es market

ex plore the sy stemic dangers and risks of deriv ativ es

surv ey the ongoing regulatory changes in the

identify the operational and technical challenges of

discuss the importance of information technology in

Financial Deriv ativ es

A derivative is an instrument deriv ed from at least one

Find answers on theperformance is deriv ed from the underly ing—hence the

name derivative. An ex ample of a deriv ativ e is an option

Deriv ativ es can be div ided into two major categories:

Deriv ativ e instruments are distinguished from other

Life span. Unlike a securities transaction (stock or

Settlem ent. Deriv ativ e contracts are settled either

Inv estm ent. Deriv ativ es—ev en those with large

Positions. Technically , market participants do not

Credit risk. The credit risk inv olv ed in deriv ativ e

Cash-flow direction. During the term of most

Risk ex posure. Deriv ativ es enable participants to

Position m anagem ent. The risk of holding a

positions is quite different from managing the position

The Deriv ativ es Market Structure

The deriv ativ es market is broadly div ided into two

Fi gure 1-1. Derivatives market segments

The listed market consists of standardized contracts traded

The listed market is also called the exchange market, the

traded on the listed market are v ariously called listed

Traditionally , trading on ex changes took place on a

Trading on ex changes is limited to standard contracts. All

The major benefits of listed markets are the following:

The obligations of listed contracts are guaranteed by

All contracts are highly standardized in nature. For

Ex change trading leads to lower transaction costs.

Clearinghouse and clearing members use a margining

Ex change-traded deriv ativ es hav e greater price

Despite the many benefits of the listed market, listed

needs of those trading deriv ativ es. Listed contracts may

Over-the-counter (OTC) is a term used to describe trading

The Bilateral OTC Market

In the bilateral OTC market, trading takes place directly

Bilateral contracts—also known as negotiated,

In principle, bilateral contracts can be formed in an

The Cleared OTC Market

In recent y ears, OTC markets hav e introduced cleared OTC

Deriv ativ es trading takes place in sev eral major v enue

Ex changes. Orders from buy ers and sellers are

Dealer m arket. Dealers either act as counterparties

Electronic trading platform s. Electronic trading

Interdealer broker. This v enue is a market in which

There is no perfect or univ ersal method for measuring the

According to a June 201 3 surv ey by BIS, the outstanding

outstanding notional of global ex change-traded deriv ativ es

Market Play ers

The deriv ativ es market is predominantly a professional

Fi gure 1-2. Derivatives market structure and players

The following list details the categories of market play ers

Buy -side firm s. Buy-side firms are also known as

Sell-side firm s. Sell-side firms are also known as

T rading v enues. Trade ex ecution v enues include

Clearing firm s. Institutions that clear trades and

Serv ice prov iders. Institutions that prov ide v arious