The Global Derivatives Market

In a chapter forthcoming in the Research Handbook on Global Capital Markets (Iain MacNeil & Iris Chiu, eds., Edward Elgar 2022), I attempt to de-mystify derivatives. The chapter starts by explaining the types of derivatives used globally and shows why derivatives can be deconstructed by their economic functions into two straightforward categories: option contracts and guarantees (the latter representing promises or assurances that certain conditions will be fulfilled).

The chapter then discusses the types of derivatives markets—exchange traded and over-the-counter. Exchange traded derivatives (‘ETDs’) are traded on exchanges, such as the Chicago Board of Trade, the London Metal Exchange, and the Tokyo International Financial Futures Exchange. The exchanges set standardized terms for these contracts, which facilitate trading and provide liquidity for investors. The exchanges also provide for the clearing and settlement of these transactions through central counterparty clearinghouses (‘CCPs’), which are generally well-capitalized entities that legally substitute their credit for that of the contracting parties, thereby reducing so-called counterparty risk.

Over-the-counter (‘OTC’) derivatives are not traded on major exchanges; instead, they usually are bought and sold pursuant to privately negotiated contracts. In a typical transaction, the end-user of the derivative will contract with a dealer who will quote a price and execute the trade. Dealers tend to be large financial institutions and intermediaries with the capital and expertise to arrange complex, high-value transactions.

The chapter also explains the uses of derivatives for hedging and risk management, as well as for generating income. For example, parties sometimes purchase derivatives to protect against fluctuations in exchange rates, interest rates, or the cost of raw materials. This ‘hedging’ shifts the risk that those fluctuations might affect future cash flows to a counterparty. Parties also use derivatives to generate income by taking advantage of price fluctuations in underlying assets. Say, for example, that an investor who expects the market price of a company’s stock to rise invests in a right to purchase (a ‘call option’) a certain quantity of that stock for a specified price at a future date. In effect, the investor is betting that the stock price will rise above that specified price, in which case it will be able to purchase that stock for less than its market price.

The chapter then explains how derivatives are regulated. For example, the 2007-2008 global financial crisis highlighted vulnerabilities in OTC derivatives markets. In response, the G20 nations committed to regulation that requires all standardized derivatives to be centrally cleared and settled through CCPs to reduce counterparty risk.

The chapter also examines possible future derivatives regulation, arguing that derivatives currently are both under- and overregulated and also that so-called close-out netting should be regulated because it can exacerbate systemic risk. Regulation currently treats derivatives as uniquely risky instruments because the value of the underlying asset can fluctuate. As mentioned, all standardized derivatives are now required to be centrally cleared through CCPs. This requirement arguably represents overregulation because, notwithstanding potential fluctuations, derivatives counterparties can usually estimate the limits of their potential liability.

Furthermore, the perception that derivatives are uniquely risky masks the reality that certain derivatives are much riskier than others. The riskiest type of derivative may well be a credit-default swap (‘CDS’), which functions like a financial guarantee. CDS contracts can be especially risky for several reasons, including that buyers of protection under these contracts are not always required to have an ‘insurable interest’ in the financial obligation being guaranteed. These so-called ‘naked’ CDS contracts have heightened risk because, among other reasons, they can be used purely for speculation.

Close-out netting refers to the netting of offsetting derivatives obligations upon the occurrence of an insolvency or default, allowing a derivatives counterparty to terminate outstanding obligations and net the amounts mutually owing between the parties. The primary argument in favor of close-out netting is that it may reduce systemic risk; absent that netting, some fear that stays imposed on counterparties of a failed derivatives dealer would lock them into long-term derivatives positions of constantly changing value. The primary arguments against close-out netting are that it not only undermines debtor reorganization but also (inadvertently) can increase systemic risk by motivating counterparties to liquidate assets before close-out netting becomes operative. The actual impact of insolvency close-out netting is still unresolved.

Finally, the chapter introduces possible next-generation derivatives, including climate-risk-related derivatives and cryptocurrency derivatives. For example, the increasing environmental, social, and governance (‘ESG’) focus in finance and investments might drive the development of new derivatives products to protect against climate-change risks. Agricultural industries could hedge these risks by entering into derivatives with counterparties that have different climate outlooks.

Steven L. Schwarcz is the Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law and Senior Fellow of the Centre for International Governance Innovation