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MEMO/09/314
Brussels, 3rd July 2009
Derivatives Markets – Frequently Asked Questions
(see IP/09/1083)
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.
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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.
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 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.
POLICY OPTIONS
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.
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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 bilaterallycleared 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.
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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).
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