Market safety and integrity for derivatives
The global derivatives market is a main pillar of the international financial system and the economy as a whole. Today, businesses around the world use derivatives to effectively hedge risks and reduce uncertainty about future prices. Derivatives contribute to economic growth and increase the efficiency of markets by improving price discovery for assets. It is important to note that derivatives did not cause the financial crisis and need to be differentiated from securities, e.g. equities, bonds or structured securities (ABS, CDOs, CLOs etc.). Nevertheless, the derivatives market has certainly been affected by and has played a role in the recent market turbulences.
This was inevitable for two main reasons: first, its sheer size with US$605 trillion in notional amount outstanding and a gross market value of US$25 trillion as of June 2009; and second, the relevance of derivatives for the global financial system. In the course of the crisis, major market participants have reached the brink of default or failed, and have generated unprecedented oscillations in market volatility.
Some parts of the market and its institutions have proven resilient, particularly derivatives traded on exchanges as well as derivatives cleared by central counterparties (CCPs). On the occasion of the default in September 2008 of Lehman Brothers International (Europe), one of the largest derivatives players globally, central counterparties almost fully resolved all open positions within a short period of time.
At the same time, the financial crisis has unearthed deficiencies in less or non-regulated segments of the derivatives market that lack adequate risk management and mitigation as well as the necessary level of transparency. Excessive bilateral exposures with insufficient collateralization were built up in the OTC derivatives market and exacerbated the financial crisis. As market participants in the OTC derivatives market segment are highly interconnected, defaults of system-relevant market participants could have caused disruption within the whole financial system. In order to minimize this systemic risk and to create a well-functioning market, both safety and integrity need to be ensured. As such, a blueprint that effectively reduces the systemic risk in the derivatives market should incorporate the following guidelines:
- Maximum use of derivatives trading on organized markets
- Maximum use of central counterparties where trading on organized markets is not feasible
- Bilateral collateralization of derivatives exposure (preferably handled by a third party) when organized trading or the use of CCPs is not feasible
- Mandatory registration of open risk positions and reporting standards for all derivative contracts
A joint effort by market participants, infrastructure providers and regulators is required to strive for a swift and consistent implementation of the blueprint in order to restore and sustainably strengthen market safety and integrity.
Such reforms are all the more important since derivatives provide a range of benefits by enabling the exchange of future risks. Not only can businesses around the world effectively use derivatives to hedge risks by reducing uncertainty about future prices, derivatives also foster investments, since investors can achieve better returns at a lower cost. In this way, derivatives fulfill an important function in the price discovery of assets.
The most important benefit of derivatives is the ability to manage market risk, i.e. to lower the actual market risk level to the desired one. This task of minimizing or eliminating risk, often called hedging, means that derivatives can safeguard corporates and financial institutions against unwanted price movements. For example, an airline can today lock in the price for fuel needed at a future point in time using a kerosene forward. Even with a minimum upfront investment, derivatives serve to limit the volatility of companies’ cash flows. This in turn gives rise to more reliable forecasting, lower capital costs, and higher capital productivity – all of which contribute to economic growth.
A second essential function fulfilled by derivatives is price discovery, allowing investors to trade on future price expectations. By trading in derivatives, investors effectively disclose their beliefs on future prices and increase the amount of information available to all market participants. In this way, derivatives enhance valuation and thereby allocation efficiency. For example, investors can take positions against the market if they expect an asset to drop in value (e.g. a derivatives contract to sell a single stock). Alternatively, they can take the market position (e.g. a futures contract on a commodity) if they perceive an asset to be undervalued and expect its value to rise again in the future. Adopting such strategies is important to reduce the risk of assets being subject to under- or overvaluation and allows a consistent valuation over time. Derivatives have further benefits. They can be employed for hedging and investment purposes at very low transaction costs, especially in comparison to investing directly in the underlying. In addition, derivatives enable rapid innovation of products that can be easily customized to the needs of any user.
The global derivatives market is a main pillar of the international financial system and economy. As an indispensible tool for risk management and investment purposes, derivatives are used by more than 94 percent of the world’s largest companies. They contribute to improving operational, information, price, valuation and allocation efficiency, thus substantially increasing the efficiency of financial and commodity markets. Derivatives help lower the cost of capital and enable firms to effectively invest
and channel their resources. These factors are an important driver of economic growth. Europe – as the most important region in the global derivatives market – stands to benefit immensely from the positive impact of derivatives.
For further information, see the Deutsche Börse White Paper “The Global Derivatives Market. A Blueprint for Market Safety and Integrity”, available under the following link:
About Stefan Mai
Executive Director, Head of Market Policy & European Public Affairs, Deutsche Boerse, Germany
2005 to 2010
Director, Head of Market Policy, Deutsche Boerse, Germany
2002 to 2005
Senior Economist Market Policy, Deutsche Boerse, Germany, and delegate of Deutsche Boerse to the International Monetary Fund, Washington D.C.
PhD in Economics at Cologne University, Germany
1999 to 2002
Research Assistant at Institut für Wirtschaftspolitik (Institute for Economic Policy), Cologne University, Germany