Brussels, 3 rd July 2009
Derivatives Markets – Frequently Asked Questions
DERIVATIVES AND DERIVATIVES MARKETS
What are derivatives?
Derivatives are financial instruments whose value is derived from the value of an underlying asset (e.g. the price of an equity, bond or commodity) or market variable (e.g. an interest rate, an exchange rate or a stock index). The main types of derivatives are: forwards, futures, options and swaps.
Why are they important?
Derivatives are financial contracts that trade and redistribute risks generated in the real economy, and are accordingly important tools for economic agents to transfer risk. They can accordingly be used for insuring against risk (hedging). However, derivatives have increasingly become used to acquire risk with the aim of making a profit (speculation and arbitrage). An important feature of derivatives is that they allow those who use them to obtain leverage: with a relatively small outlay, the investor is able to take a large position in the market.
What are OTC markets?
Over-the-counter (OTC) is a method of trading that does not involve an exchange. Instead, participants trade directly with each other. Traditionally, OTC trades have been concluded over the phone (voice brokerage) but are increasingly taking place on electronic networks (e.g. on electronic networks between dealers or between dealers and their clients).
What are OTC derivatives?
OTC derivatives are simply derivatives traded on OTC markets. Their main difference from the derivatives traded on exchanges lies in their highly bespoke nature: whereas on-exchange derivatives are traded on standard terms (e.g. there is a limited choice of strike prices or maturities that can be traded), OTC derivatives are non-standardised, offering full flexibility in deciding those terms. They are accordingly tailor-made to fit the specific risk management needs of investors.
Why are OTC derivatives markets regarded as more risky than exchange-traded derivatives markets?
OTC markets are characterised by private contracting between numerous counterparties with limited public information. The bilateral nature of these markets creates a complex web of mutual dependence between counterparties. Coupled with the markets' opaqueness this creates a situation in which it is difficult for both market participants and regulators to fully understand the true nature and level of risks that any particular market participant is exposed to. This increases uncertainty in times of market stress and can accordingly undermine financial stability as it has been clearly illustrated by the current financial crisis.
Finally, an additional factor that needs to be taken into account is the extreme concentration of some market segments, which entails severe implications in case one of the players defaults.
THE FINANCIAL CRISIS
What role have derivatives played in the financial crisis?
Although OTC derivatives markets were not responsible for the onset of the crisis, they played both a direct and an indirect role in its propagation. The direct role was epitomised by the near failure of AIG due to its dealings in the credit default swaps market. The indirect role had more to do with the participants in those markets. Bear Sterns and Lehman Brothers, two of the institutions that got swept away by the crisis were important players in the OTC derivatives markets, either as dealers or users of OTC derivatives, or both. They got into trouble due to substantial losses that originated outside the OTC derivatives markets. However, due to the central role played by these two institutions in the OTC derivatives markets and beyond, their trouble affected the entire global financial system.
Hasn't the crisis shown that OTC derivatives markets work well? At the end of the day, those markets handled the default of Lehman Brothers smoothly, closing the latter's positions without any major losses for its counterparties.
This is true only up to a point. In the days following Lehman's default the already impaired liquidity in the inter-bank money market ground to a halt, largely due to the uncertainty (and consequent mistrust) that the default created among the participants in that particular market. Indeed, due to the opaqueness of the OTC derivatives markets, the participants did not know their counterparties' exposures to Lehman. In such a highly uncertain environment they decided not to lend their money to one another because of fear that it would not be repaid. Also, let us not forget that OTC derivatives played a leading role in the demise of AIG.
CREDIT DEFAULT SWAPS (CDS)
What are CDS?
A CDS is in many ways similar to an insurance contract. In exchange for paying an annual premium the CDS buyer (i.e. the protection buyer) is insured against losses caused by a credit event (e.g. a default) related to the debt of a specific reference entity (e.g. a company or a bank). The analogy with an insurance contract stops here: the protection buyer does not need to own the underlying debt in order to be able to purchase the CDS. However, in order to be able to collect the "insurance" payment from the CDS seller (i.e. the protection seller) in case a credit event does occur, the protection buyer must deliver an equivalent amount of the debt (bonds or loans) of the reference entity to the protection seller.
What is a credit event?
It is an event that may trigger the exercise of a CDS contract. Typically, credit events include failure to pay (interest or principal when due), bankruptcy or restructuring.
Why have CDS been singled out as particularly risky?
Credit derivatives markets are built on products that bind together institutions and markets in ways that are difficult to understand and survey both at institutional and systemic level. While CDS are relatively small compared to other OTC derivatives markets, they are particularly significant in terms of risk:
The CDS market is highly concentrated: a handful of banks is behind between 80 and 90 percent of all outstanding contracts. A failure of any of them can have severe implications for the CDS market and for financial markets as a whole, as the Lehman case demonstrated.
The total gross notional amount of outstanding CDS was a multiple of the total amount of underlying debt on which these contracts were written.
The pay-off of a CDS is discontinuous. In exchange for a continuous stream of revenue from the protection buyer, the protection seller assumes the risk of having to pay out the full amount of the insurance if the reference entity on which the CDS is written defaults. As the revenue he receives is usually but a fraction of the payment that he would need to make, he is exposed to the risk of incurring a substantial loss in case a default does occur.
Contracts are non-fungible. Because of this, market participants that wish to close a position can only do so by going back to the original counterparty (usually a dealer) or by entering into an offsetting contract with a different counterparty. In the latter case, the net exposure of the participant is reduced to zero. However, the risk associated with the two contracts is not completely removed, as counterparty risk remains (if one of the counterparties defaulted, the hedge would be undone). This is why gross exposure matters.
Pricing CDS is difficult. Compared to interest rate swaps, where risks are well understood and contracts rely on widely available and tested data for their pricing (e.g. share prices, interest rates, exchange rates), the data needed to price CDS (e.g. firms' balance sheets) is more scarce and often less authoritative. Therefore the probability of mispricing CDS is higher than is the case with other types of derivatives.
There is a pro-cyclical element to CDS. As highlighted by the Turner Review, CDS prices systematically understate risk in the upswing and overstate it in the downswing. Unrestricted CDS trading can accordingly make the price of credit more volatile, which at the extreme can even trigger credit events. Such events create significant disruption costs on the real economy. This is particularly dangerous when the object of the CDS is a bank: in view of banks' central role in the economy, a bank failure has particularly serious consequences for the economy.
Where does industry stand as regards central counterparty (CCP) clearing for CDS?
The major derivatives dealers have signed a commitment letter with the European Commission to move clearing of European-referenced CDS onto one or more European CCPs by 31 July 2009. They are currently working on the necessary standardisation of European CDS contracts and related procedures to make this move possible. On the CCP side, two European CCPs are expected to be ready to offer their services on CDS by 31 July 2009, a third one is expected to be ready in December 2009 and a fourth one has not committed to a firm date.
What will the Commission do if industry does not meet its commitment?
If industry is unable to deliver on its commitment, the Commission will have to consider other ways to incentivise the use of CCP clearing.
Why is it necessary to have a CCP in Europe? Would this not be inefficient?
There are strong reasons for insisting on CCP clearing being located in Europe, relating to, among others, regulatory, supervisory and monetary policy concerns. If the CCP is located in Europe, it is subject to European rules and supervision. Supervisors accordingly have undisputed and unfettered access to the information held by CCPs. If the CCP was located outside Europe, EU supervisors would have to rely on third country supervision. This would be unsatisfactory, especially in times of market stress. It is also easier for European authorities to intervene in case of a problem at a European CCP. For example, no central bank will provide liquidity to institutions located outside its currency area.
What do you have in mind when you talk about standardisation of OTC derivatives contracts?
Roughly speaking, standardisation has two dimensions, i.e. the standardisation of the "legal" terms of the contracts (e.g. applicable law, dispute resolution mechanism etc.) and the standardisation of the "economic" terms of the contracts (e.g. in the case of CDS the maturity of the contract, the coupon to be paid etc.).
For example, Master Agreements developed by the International Swaps and Derivatives Association (ISDA) represent the first type of standardisation. The recent market agreement to use only a handful of standardised coupon values for European-referenced CDS is an example of the second type of standardisation.
Why is standardisation necessary?
Conducting trades under the framework of widely adopted, standard contractual terms increase legal certainty and reduce legal risk. Moreover, standardisation increases operational efficiency, as it enables automating the structure of the trading and post-trading value chain. Standardisation may also reduce counterparty credit risk, as it enables a wider usage of CCP clearing or exchange trading. Standardisation is accordingly a sine qua non for delivering efficient, safe and sound derivatives markets.
What are central data repositories?
A central data repository collects data on contracts traded in one or more segments of the OTC derivatives markets (both CCP eligible and CCP non-eligible). Through a central data repository one can therefore obtain information on, for example, the number of outstanding contracts, the size of outstanding positions in a particular contract etc. This not only contributes to transparency, but also improves the operational efficiency of the market. A repository can also provide other services (e.g. facilitate settlement and payment instructions).
A data repository exists for CDS in the form of the Trade Information Warehouse, operated by the US Depository Trust and Clearing Corporation (DTCC).
What is a Central Counter-party (CCP)?
A CCP is an entity that interposes itself between the counterparties to a transaction, becoming the buyer to every seller and the seller to every buyer.
What are the benefits of CCP clearing?
First, it allows counterparty risk mitigation and reduces the risk of contagion in case of the failure of a market participant. Counterparty risk mitigation is guaranteed by novation (i.e. the process through which the original bilateral contract is replaced by two contracts between the CCP and each of the original counterparties), by multilateral netting and by robust margining procedures and other risk management controls that render the CCP the most creditworthy counterparty. The risk of contagion is reduced through loss mutualisation: in case of the default of a CCP's participant, if the collateral provided by the latter is not sufficient to cover the loss, other participants are required to share that loss (up to the value of their contribution to the default fund of the CCP).
Second, it has a positive effect on market liquidity. Provided that the CCP clears a sufficient number of asset classes, the usage of a CCP for OTC derivatives may allow a member to free capital for other purposes, as less collateral should be required, thanks to multilateral netting, payment netting and possible cross-margining arrangements with exchange-traded contracts, all resulting in increase of liquidity.
Third, it solves disruptive information problems. When a major player in bilaterally-cleared derivatives markets fails, it is not immediately apparent to the remaining market participants whether and to what extent their counterparties have been affected by this failure. The effects of this uncertainty can be devastating on market confidence. This uncertainty is virtually eliminated by the presence of a CCP in the market.
Fourth, it increases operational efficiency. As the counterparty of all trades a CCP establishes the margin and collateral requirements for all the participants, centralises the necessary calculations, marks to market open contracts and collects or pays the respective amounts in automated ways, reducing disputes and increasing efficiency.
Finally, it allows regulatory capital savings since it is considered a zero risk counterparty.
CCPs have proven to be resilient even under stressed market conditions as the one we are facing today and showed their ability to ensure normal market functioning in case of failure of a major market player (e.g. LCH.Clearnet's successful unwinding of the interest rate swap positions left open following the default of Lehman Brothers).
What is an organised trading venue?
An organised trading venue is a venue where trades are executed in an automated manner according to pre-defined rules and where prices and other trade-related information are publicly displayed. In MiFID terms, public trading venues would be either regulated markets or multilateral trading facilities (MTFs).