Derivatives market

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The derivatives markets are the financial markets for derivatives. The market can be divided into two, that for exchange traded derivatives and that for over-the-counter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both.

Futures markets

Futures exchanges, such as Euronext.liffe and the Chicago Mercantile Exchange, trade in standardized derivative contracts. These are options contracts and futures contracts on a whole range of underlying products. The members of the exchange hold positions in these contracts with the exchange, who acts as central counterparty. When one party goes long (buys) a futures contract, another goes short (sells). When a new contract is introduced, the total position in the contract is zero. Therefore, the sum of all the long positions must be equal to the sum of all the short positions. In other words, risk is transferred from one party to another. The total notional amount of all the outstanding positions at the end of June 2004 stood at $53 trillion. (source: Bank for International Settlements (BIS): [1]). That figure grew to $81 trillion by the end of March 2008 (source: BIS [2])

Over-the-counter markets

Tailor-made derivatives not traded on a futures exchange are traded on over-the-counter markets, also known as the OTC market. These consist of investment banks who have traders who make markets in these derivatives, and clients such as hedge funds, commercial banks, government sponsored enterprises, etc. Products that are always traded over-the-counter are swaps, forward rate agreements, forward contracts, credit derivatives, etc. The total notional amount of all the outstanding positions at the end of June 2004 stood at $220 trillion. (source: BIS: [3]). By the end of 2007 this figure had risen to $596 trillion (source: BIS: [4])

Netting

Global: OTC Derivatives Markets The notional outstanding value of OTC derivatives contracts rose by 40% from $298 trillion at end-2005 to $415 trillion at end-2006. Average daily global turnover rose by two thirds from $1,508bn to $2,544bn between April 2004 and April 2007. The UK remains the leading derivatives centres worldwide with its share of turnover stable at 43% in 2007. The US is the only other major location with 24% of trading (Chart 2). Interest rate instruments remain the key driver of trading, accounting for 88% of UK turnover and 70% of global notional value (Chart 3 & Table 2). Derivatives based on foreign exchange contracts account for a further 10% of notional value, with credit, equity-linked and commodity contracts also important. Energy, metal and freight derivatives have grown rapidly in recent years. The euro’s share of interest rate derivatives turnover worldwide has risen to 39% while the US dollar has fallen to 32%: pound sterling and yen also increased their market share over the past three years. Trading is becoming more concentrated amongst the largest banks, while other financial institutions such as hedge funds, mutual funds, insurance companies and smaller banks have become much bigger users of derivatives. [5]

US: Figures below are from SECOND QUARTER, 2008 [6]

• Total derivatives (notional amount): $182.2 trillion (SECOND QUARTER, 2008)
  • Interest rate contracts: $145.0 trillion (80%)
  • Foreign exchange contracts: $18.2 trillion(10%)
  • 2008 Second Quarter, banks reported trading revenues of $1.6 billion
• Total number of commercial banks holding derivatives: 975

[7]

According to Bank for International Settlements "$516 trillion at the end of June 2007"

Positions in the OTC derivatives market have increased at a rapid pace since the last triennial survey was undertaken in 2004. Notional amounts outstanding of such instruments totalled $516 trillion at the end of June 2007, 135% higher than the level recorded in the 2004 survey (Graph 4). This corresponds to an annualised compound rate of growth of 33%, which is higher than the approximatively 25% average annual rate of increase since positions in OTC derivatives were first surveyed by the BIS in 1995. Notional amounts outstanding provide useful information on the structure of the OTC derivatives market but should not be interpreted as a measure of the riskiness of these positions. Gross market values, which represent the cost of replacing all open contracts at the prevailing market prices, have increased by 74% since 2004, to $11 trillion at the end of June 2007. (page 28, http://www.bis.org/publ/qtrpdf/r_qt0712.pdf) [8]

Controversy about the financial crisis

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The derivative markets have been accused lately for their alleged role in the financial crisis. The leveraged operations are said to have generated an “irrational appeal” for risk taking, and the lack of clearing obligations also appeared as very damaging for the balance of the market. The G-20’s Financial-Market Regulation proposals are all stressing these points out, and suggest:

• higher capital standards
• stronger risk management
• international surveillance of the financial firms operations
• dynamic capital rules

See also

• Commodity markets
• Securitization
• Financial engineering