Capital Markets: Derivatives 2024

Introduction to Derivatives

Derivatives have become an integral part of the global financial landscape, with transaction volumes growing dramatically over the years. These powerful financial instruments, whose value is derived from underlying assets such as stocks, bonds, commodities, currencies, interest rates, or market indexes, play a crucial role in risk management and speculative opportunities worldwide.

The derivatives industry has undergone significant changes, shaped by global events like the 2008 financial crisis, which prompted a wave of regulatory reforms aimed at enhancing market stability and transparency. Today, derivatives are traded on regulated exchanges and over-the-counter (OTC) markets in major financial centres around the world, including New York, London, Tokyo, and Hong Kong.

There are several main types of derivatives, each with its own unique characteristics and purposes:

• Futures: Contracts obligating the buyer to purchase, or the seller to sell, an asset at a predetermined future date and price.
• Options: Contracts giving the buyer the right, but not the obligation, to buy or sell an asset at a set price within a specific period.
• Forwards: Customised contracts between two parties to buy or sell an asset at a specified future date for a price agreed upon today.
• Swaps: Agreements to exchange cash flows or other financial instruments between parties over a set period.
• Contract for Differences: Contract for Differences (CFDs) are derivatives that allow traders to speculate on price movements of assets, settling the difference in value between opening and closing prices in cash, without physical delivery of the underlying commodity. CFDs are deemed to be swaps in the United States but are considered a distinct type of derivatives product in some other jurisdictions.

While derivatives are powerful tools for risk management, allowing businesses to protect against price volatility, currency fluctuations, and interest rate changes, they also carry significant risks, including market, credit, and liquidity risks. Most jurisdictions place considerable restrictions on who can trade derivatives, how these instruments are traded, and whether certain post-execution activities (eg, mandatory clearing, imposition of margin, risk mitigation measures) must occur.

The regulatory environment for derivatives varies by country but has seen increased oversight and reform over the last decade. The primary regulatory bodies in some of the most active trading jurisdictions (by trading volumes) include the U.S. Commodity Futures Trading Commission (CFTC), the European Securities and Markets Authority (ESMA), Financial Conduct Authority (FCA) of the United Kingdom, the Financial Services Agency of Japan (FSA), and Monetary Authority of Singapore (MAS).

This guide aims to provide a clear understanding of derivatives, their types, global market impact, regulatory landscape, helping business professionals navigate the complexities of this rapidly evolving financial environment. This guide will also cover recent developments in the derivatives market, including but not limited to international co-operation, novel products, technological innovations, and improved risk management of central counterparties (CCPs).

Markets and Size

Derivatives markets play a vital role in the global economy, such as enabling commercial businesses to raise financing at competitive rates and effectively manage their exposures to various. This, in turn, allows these businesses to invest and grow, spurring economic growth. The size of the derivatives market is staggering, with the notional value of outstanding derivatives growing by 8% in 2023 to reach USD667 trillion. Interest rate derivatives (IRDs), the largest component of the global aggregate, also rose by 8% year-on-year to USD530 trillion.

As noted above, derivatives are traded on both regulated exchanges and OTC markets. Exchange-traded derivatives are standardised contracts traded on regulated exchanges, offering price transparency, and liquidity. Major derivatives exchanges include the Chicago Mercantile Exchange (CME), Eurex, and the Tokyo Financial Exchange. These exchanges operate under strict regulatory frameworks to ensure market integrity and protect investors, with rules covering contract specifications, trading procedures, margin requirements, and reporting obligations. In some jurisdictions, certain derivatives, such as futures contracts, options on futures contracts and certain types of standardised swaps, are required to trade on a regulated exchange.

On the other hand, bespoke derivatives are traded OTC, which means that these contracts are traded directly between parties or through brokers or electronic trading platforms. While the OTC markets offer flexibility, they come with higher counterparty risk compared to exchange-traded derivatives. Post-2008 financial crisis reforms, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in the United States and the European Market Infrastructure Regulation (EMIR) in Europe, have increased oversight of OTC markets, introducing requirements for trade reporting, central clearing, registration of certain large market participants, and risk mitigation.

Clearing of derivatives ensures that trades are settled efficiently and securely through a central clearinghouse. A clearinghouse manages the risk between buyers and sellers by guaranteeing the terms of the contract, ensuring each party fulfils its respective obligations. Clearinghouses centralise and standardise transactions, reducing counterparty risk and enhancing market stability, thereby playing a crucial role in safeguarding the global financial system against systemic shocks. This process fosters market stability and trust, enabling businesses to manage their financial exposures effectively. With more and more derivatives becoming subject to mandatory clearing, systemic risk concerns have shifted from too-big-to-fail market participants to regulated clearinghouses.

Key participants in derivatives markets include institutional investors, hedge funds, commercial hedgers, retail traders, banks, corporations, and asset managers. Each group has different motivations, ranging from hedging risk to seeking profit through speculation. While derivatives offer many benefits, they also involve various risks, including market risk, liquidity risk, operational risk, and counterparty risk. Effective risk management strategies and regulatory compliance are essential for mitigating these risks.

Regulators monitor and assess the activities of key players in the derivatives market by requiring the registration of clearinghouses, trade repositories, and large market participants. By mandating registration, regulators gain valuable insights into the operations, risk management practices, and financial health of these entities. This transparency allows for more effective supervision and helps identify potential systemic risks before they escalate. Further, registration often comes with specific compliance obligations, ensuring that these institutions adhere to established standards of conduct, reporting, and risk management. As the derivatives market continues to evolve, the registration process also provides a framework for regulators to adapt their oversight to new and emerging market developments.

History of Derivatives

Derivatives have a rich history dating back to ancient civilisations, where farmers and merchants used forward contracts to lock in prices for agricultural products. Aristotle recounts the renowned case of Thales’s market corner in the 6th century BCE. Thales, so the story goes, was weary of the jeers of his contemporaries that his interest in philosophy and astronomy was useless, and the reason for his impoverished state. Having observed the correlations between climate and olive harvests in his native Miletus (on the west coast of present-day Turkiye), he predicted over the course of an unusually mild winter that there was going to be a large crop of olives. So, he raised a small sum of money and bought or rented all the olive presses in the region. When the bumper harvest came and the demand for presses exploded, Thales’s corner of the market for olive presses paid off – so proving, as Aristotle concludes, “that it is easy for philosophers to be rich if they choose, but this is not what they care about.”

The 19th century saw the creation of futures exchanges for agricultural commodities, with the Chicago Board of Trade (CBOT) in the United States, established in 1848, playing a pivotal role in the development of standardised futures contracts. With the introduction of financial futures in the 1970s, the derivatives market expanded beyond derivatives on agricultural commodities to encompass derivatives on financial products such as interest rates, currencies, and stock indices.

Swaps emerged as a key derivative product in the 1980s, starting with currency swaps and followed by interest rate swaps. Companies and financial institutions entered into swaps to manage exposure to fluctuations in interest rates and exchange rates. The 1990s witnessed a rapid expansion in the use and variety of derivatives, including the introduction of credit default swaps (CDS) and the significant growth of OTC markets.

However, global financial crises have highlighted the risks associated with derivatives. The 1997 Asian Financial Crisis and the 2008 Global Financial Crisis underscored the systemic risks posed by derivatives, particularly in the mortgage-backed securities market and CDS, leading to catastrophic losses for major financial institutions and prompting calls for regulatory reform.

In response to the 2008 Global Financial Crisis, leaders of the G20 met in Pittsburgh in 2009 and agreed on comprehensive reforms to increase transparency and reduce risks in the OTC derivatives markets. These agreements reached among world leaders resulted in the establishment of key principles for the regulation of OTC derivatives, including required clearing of standardised OTC derivatives through CCPs and reporting of OTC derivatives trades to trade repositories. Policymakers in various jurisdictions enacted significant regulatory reforms, including Dodd-Frank and EMIR, and regulatory bodies promulgated stringent rules to oversee derivatives activities, aiming to mitigate systemic risks, enhance market transparency, and protect market participants.

Organisation of Topics

The world of derivatives is complex, dynamic, and critically important to global financial markets. This comprehensive guide aims to provide a thorough understanding of derivatives, from their fundamental concepts to the intricate regulatory landscape and current enforcement trends. By exploring the various types of derivatives, their regulation, documentation practices, and recent enforcement activities, readers will gain valuable insights into this sophisticated financial domain.

This guide is organised into the following chapters:

• General: This section provides a foundational understanding of the derivatives markets, setting the stage for a more detailed explanation of specific derivative types, their regulation, documentation, and enforcement trends.
• Types of Derivatives: Building on the general overview and historical context, this section delves into the specific types of derivatives, examining their unique characteristics, regulatory aspects, and emerging trends.
• Regulation of Derivatives: This section focuses on the roles of various regulatory bodies and specific regulatory requirements. It identifies national regulators and their jurisdictions, and outlines rules on clearing, mandatory trading, position limits, and reporting. It also covers regulation of derivatives at subnational and supranational levels. Lastly, it considers oversight by self-regulatory organisations and exchanges.
• Documentation Issues: After establishing the regulatory framework, this section addresses the documentation practices critical for trading and clearing derivatives, highlighting industry standards and specific requirements. It covers industry standards for derivatives documentation and addresses specific requirements for trading agreements, margin documentation, and legal opinions.
• Enforcement Trends: This section examines recent enforcement activities and trends, providing insights into regulatory priorities and compliance expectations.

Recent Developments and International Co-operation

In recent years, the global derivatives market has undergone significant changes, driven by increased international co-operation, novel products, technological innovations, and improved risk management of CCPs. These advancements have aimed to create a more robust and harmonised financial landscape, ensuring the resilience and efficiency of derivatives markets. We briefly summarise each of these topics below.

• International Co-operation: International regulatory bodies, such as the International Organization of Securities Commissions (IOSCO), and industry organisations, like the International Swaps and Derivatives Association (ISDA), have played a crucial role in facilitating the harmonisation of regulations across jurisdictions. By providing standardised documentation and promoting best practices, these organisations work to reduce regulatory arbitrage and enhance market stability. The implementation of substituted compliance and regulatory equivalence also allows market participants to adhere to their home country’s regulatory standards while operating internationally, promoting cross-border regulatory harmonisation, reducing compliance costs, and ensuring market efficiency.
• Novel Products: The derivatives market has witnessed a surge in novel products, driven by technological advancements and changing investor priorities. For example, blockchain technology has paved the way for derivatives referencing digital assets such as cryptocurrencies, stablecoins, and tokenised commodities. Additionally, the growing importance of sustainable investing has led to the emergence of Environmental, Social, and Governance (ESG) derivatives, including voluntary carbon credit derivative contracts. These new and sophisticated instruments cater to the evolving needs of investors and allow them to explore additional ways to hedge risks and amplify investment strategies.
• Technological Advancements: Technological advancements, including algorithmic trading, blockchain technology, and artificial intelligence, are transforming derivatives markets by enhancing efficiency, transparency, and risk management. However, these innovations also present novel legal and regulatory risks and considerations that require careful consideration by regulators and market participants alike.
• CCP Risk Management: Innovations such as real-time monitoring and stress testing have helped enhance the resilience of clearinghouses. Nevertheless, the increasing interconnectedness of global markets, the emergence of novel financial instruments, and the potential for systemic shocks require CCPs to constantly adapt their risk management frameworks and maintain robust safeguards to ensure the stability and integrity of the financial system.

Derivatives have evolved significantly from their early origins and become integral to modern financial markets. Despite their benefits in risk management, the complexity and potential risks of derivatives require ongoing regulatory oversight and prudent use by market participants. The future of derivatives will likely continue to be shaped by technological innovations, regulatory developments, and the changing needs of the global economy.

* The firm would also like to thank Alexander C. Kim and Nicholas Gervasi for their contributions to this introduction.