OTC and Exchange Traded Derivatives

Over-the-counter

Some derivatives like interest rate and currency swaps are traded directly between two parties. When they deal, they agree the amount, price, settlement date and maturity date of the transaction. Traditionally the details of these transactions are only known by the parties involved (but now regulatory reporting applies).

The advantage of this bilateral approach is flexibility. You and your counterparty agree exactly what you want to. Therefore, you can tailor the trade to suit your needs. There is also choice. You can deal with any counterparty provided you both agree. It is argued this keeps the market efficient. But there is a risk. Many of these trades are long dated. They depend on paying and receiving money in the future. What happens if your counterparty fails? They can’t honour the contract.

With swaps (ignoring bid-offer spreads) neither party is making a profit or a loss when the trade is executed. But as soon the market moves one party gains and one loses. The party with the positive market value has a credit exposure on the other party. The credit risk is real.

To overcome this risks the market uses collateral management. This involves the exchange of collateral, mainly cash. The in-the-money party calls the out-of-the money party for margin. This two-way process is repeated daily on the net position exposure. But additional risks can build-up.

These are operational risks. Do you manage the process properly? How do you deal with disputes? Do you have escalation processes in place?

During the 2007/8 crisis, whilst widely used collateral management was not robustly applied by all parties leading to risks that could build up between firms. Something regulators became nervous about.

Exchange Traded

For a long time, futures contracts have been traded on exchanges (a market place that acts as an execution venue). To trade on an exchange, you need to be a member of the exchange. This is preserve of large financial firms.

Futures are standardised contracts based on an underlying commodity or financial instrument. They have set maturity dates, settlement and delivery processes. You can only trade the contract’s specifications nothing else. There is inflexibility. However, market volume is channelled through relatively few contracts and the exchange publishes trading prices. These features increase market efficiency.

Once a trade is executed on an exchange it is settled. This is where clearing comes in. Clearing is not the same as exchange trading. Clearing is what happens post trade. It is conducted by a clearing house or Central Clearing Counterparty (CCP). This is a separate third party. To clear trades a dealer needs to use a clearing broker who is a member of the clearing house.

The clearing house stands in the middle of trades and acts as counterparty to both the buyer and the seller. It guarantees the performance of both parties and therefore makes the system safer. It also has other functions. They include:

Posting daily closing prices
Facilitating delivery
Regulation (futures must be cleared)
Restricting membership – members must have sufficient capital, operational ability and risk management capability. This is continually monitored.
Capital maintenance – members must subscribe capital to a guarantee fund that covers member default
Margining – calling members for money to back outstanding trades

The clearing house looks at individual member’s open positions during the day and calls for Initial Margin (IM) based on these. The IM is a sum of money that must be posted with the clearing house to make sure that in the short run the member has sufficient funds to cover any losses on the outstanding trades. (The IM is calculated by the clearing house and is normally based on a back tested, value at risk type model using a 99% confidence interval).

When the member incurs losses on trades a further call for collateral is made by the clearing house. This is Variation Margin (VM) and it is over and above VM. Failure to pay VM would lead to the trade being closed out and the loss being taken from the IM.

Provided the process is managed properly margining is regarded as a particularly important safety feature. It is designed to prevent large credit exposures building up between clearing house members. Clearing members also pass back IM and VM to their clients. Reducing the risk, they have with them.

Regulation

Because of the financial crisis regulators have taken a closer look at both OTC and exchange traded markets. The thrust of regulation is to:

Increase the volume of trades that are traded on an exchange
To get as many trades as possible cleared through a Central Clearing Counterparty
Trades that are not cleared will have increased capital requirements
Price data to be made publicly available

The objective is to reduce systemic risk and improve price transparency in what is regarded as the wild west market of OTC derivatives.

Whether this objective will be met is a moot point. Some see it as a grab for a market dominated by large banks by exchange venues and clearing houses. It potentially increases the concentration of risk in one place, the clearing house. It may increase the cost of doing business for end users looking to hedge risk. It may lead to a reduction in liquidity if market makers pull back. Complex products are not easily margined because there are differences of opinion on how valuation is undertaken.

Swap Execution Facilities (SEFs)

To create greater price transparency, the Dodd Frank Act requires swaps to be traded and processed through a SEF. A SEF is a trading system or platform that allows cleared and uncleared swaps to be traded between market participants. The SEF must be registered with the CFTC. A SEF provides a Central Limit Order Book (CLOB) and Request For Quote Systems (RFQ), block trading facilities and electronic trade execution by brokers.

For SEFs to access market liquidity from the EEA as well as the US the SEF must also be regulated in the EU. SEF’s that are regulated in both the US and EU are known as Multilateral Trading Facilities.

CLOB: This is a market where bid and offer prices are shown along with their order size. It’s where dealers can trade with each other, customers or where customers can trade together. In this respect the market has transparent pricing and offers low cost execution.

RFQ: This is where a customer can request a price from several dealers and then picks the best price at which to deal. The customer doesn’t have the option of putting a bid or offer price into the market that is “inside” the quoted prices. “Market making” remains the preserve of the dealer.

First Published by Barbican Consulting Limited 2017