Over-the-counter derivatives and The risks of derivatives
The fastest-growing part of the financial markets in recent years has been the over-the-counter market for derivatives. Over-the-counter derivatives are transactions occurring between two parties, known as counter parties, without the intermediation of an exchange. In general, one of the parties to a derivatives transaction is a dealer, such as a bank or investment bank, and the other is a user, such as a non-financial corporation, an investment fund, a government agency, or an insurance company.
In principle, derivatives are similar to exchange-traded options. Most derivatives involve some element of optionality, such that the price depends heavily on the value attached to the option. Many of the same mathematical procedures used to determine the value of options are therefore employed in the derivatives market as well. Unlike exchange traded derivatives, however, over-the-counter derivatives can be customised to meet the investor’s requirements. As recently as the late 1980s, the market for over-the-counter derivatives barely existed. The business burgeoned in the 1990s as investors discovered that derivatives could be used to manage risk or, if desired, to increase risk in the hope of earning a higher return. Derivatives trading has also been controversial, because of both the difficulty of explaining how it works and the fact that some users have suffered large and highly publicised losses. Some observers have been alarmed by the sheer size of the market. The notional principal, or face value, of outstanding currency and interest-rate derivatives increased from just $3.5 trillion in 1990 to $217 trillion in 2004.
Although the market is large, such figures seriously exaggerate its size. A currency derivative covering $1m-worth of euros has a notional principal of $1m, but the counterparties’ potential gain or loss depends upon the amount of the euro’s fluctuation against the dollar, not the notional value. The banks that are the most important players in the derivatives market have positions whose notional value is many times their capital, but as many of these positions cancel one another out the amount that a bank could potentially lose from derivatives trading is far less than the notional value of its derivatives. On average, according to estimates by the International Swaps and Derivatives Association, a trade group, the potential loss from derivative positions is about 1–2% of the notional value of the positions. The gross market value of over-the-counter derivatives outstanding at the end of 2004 was only $9 trillion, and their net value – the amount that would have had to change hands had all the contracts been liquidated – was about $2 trillion.
The risks of derivatives
Over-the-counter derivatives pose certain risks that are less significant in the markets for exchange traded options.
Counterparty risk
For all exchange-traded options, the exchange itself becomes the counter party to every transaction once the initial trade has been completed, and it ensures the payment of all obligations. This is not so in the over-the-counter market, where derivatives are normally traded between two businesses. If the seller of a derivative becomes insolvent, the buyer may not be able to collect the money it is owed. For this reason, participants in the derivatives market pay extremely close attention to the creditworthiness of their counter parties, and may refuse to do business with entities whose credit standing is less than first-class. A large and growing share of derivatives transactions is secured by collateral, offering protection to one counter party in the event the other defaults.
Price risk
A derivatives dealer often customises its product to meet the needs of a specific user. This is quite unlike exchange-traded options, whose size, underlying and expiration date are all standardised. Customisation has advantages; for example, a firm expecting to receive a foreign-currency payment might seek a currency derivative that expires on the precise day the payment is due, rather than buying an option that expires several days earlier. But customised derivatives also have disadvantages. In particular, a user wishing to sell out its position may be unable to obtain a good price, as there may be few others interested in that particular derivative.
Legal risk
Where options are traded on exchanges, there are likely to be laws that clearly set out the rights and obligations of the various parties. The legal situation is often murkier with regard to over-the-counter derivatives. In recent years, for example, several sophisticated corporate investors have brought lawsuits charging that they were induced to buy derivatives so complex that even they could not fully understand them. In other cases, transactions entered into by government entities have been voided by courts on the grounds that the entity was not empowered to undertake such a transaction.
Settlement risk
The exchange makes sure that the parties to an option transaction comply with their obligations within strict time limits. This is not the case in the over-the-counter market. Central banks in the biggest economies have been trying to speed up the process of settling claims and paying for derivative transactions, but participants are still exposed to the risk that transactions will not be completed promptly. A particular concern is netting, the process by which all of the positions between two counter parties can be set off against each other. Without netting, it is possible that party A will have to make good on its obligations to party B, even though party B is unable to make good on its own obligations to party A. It is not clear whether netting can be legally enforced in all countries, leaving the possibility that a market participant will suffer losses despite having profitable
positions.
In principle, derivatives are similar to exchange-traded options. Most derivatives involve some element of optionality, such that the price depends heavily on the value attached to the option. Many of the same mathematical procedures used to determine the value of options are therefore employed in the derivatives market as well. Unlike exchange traded derivatives, however, over-the-counter derivatives can be customised to meet the investor’s requirements. As recently as the late 1980s, the market for over-the-counter derivatives barely existed. The business burgeoned in the 1990s as investors discovered that derivatives could be used to manage risk or, if desired, to increase risk in the hope of earning a higher return. Derivatives trading has also been controversial, because of both the difficulty of explaining how it works and the fact that some users have suffered large and highly publicised losses. Some observers have been alarmed by the sheer size of the market. The notional principal, or face value, of outstanding currency and interest-rate derivatives increased from just $3.5 trillion in 1990 to $217 trillion in 2004.
Although the market is large, such figures seriously exaggerate its size. A currency derivative covering $1m-worth of euros has a notional principal of $1m, but the counterparties’ potential gain or loss depends upon the amount of the euro’s fluctuation against the dollar, not the notional value. The banks that are the most important players in the derivatives market have positions whose notional value is many times their capital, but as many of these positions cancel one another out the amount that a bank could potentially lose from derivatives trading is far less than the notional value of its derivatives. On average, according to estimates by the International Swaps and Derivatives Association, a trade group, the potential loss from derivative positions is about 1–2% of the notional value of the positions. The gross market value of over-the-counter derivatives outstanding at the end of 2004 was only $9 trillion, and their net value – the amount that would have had to change hands had all the contracts been liquidated – was about $2 trillion.
The risks of derivatives
Over-the-counter derivatives pose certain risks that are less significant in the markets for exchange traded options.
Counterparty risk
For all exchange-traded options, the exchange itself becomes the counter party to every transaction once the initial trade has been completed, and it ensures the payment of all obligations. This is not so in the over-the-counter market, where derivatives are normally traded between two businesses. If the seller of a derivative becomes insolvent, the buyer may not be able to collect the money it is owed. For this reason, participants in the derivatives market pay extremely close attention to the creditworthiness of their counter parties, and may refuse to do business with entities whose credit standing is less than first-class. A large and growing share of derivatives transactions is secured by collateral, offering protection to one counter party in the event the other defaults.
Price risk
A derivatives dealer often customises its product to meet the needs of a specific user. This is quite unlike exchange-traded options, whose size, underlying and expiration date are all standardised. Customisation has advantages; for example, a firm expecting to receive a foreign-currency payment might seek a currency derivative that expires on the precise day the payment is due, rather than buying an option that expires several days earlier. But customised derivatives also have disadvantages. In particular, a user wishing to sell out its position may be unable to obtain a good price, as there may be few others interested in that particular derivative.
Legal risk
Where options are traded on exchanges, there are likely to be laws that clearly set out the rights and obligations of the various parties. The legal situation is often murkier with regard to over-the-counter derivatives. In recent years, for example, several sophisticated corporate investors have brought lawsuits charging that they were induced to buy derivatives so complex that even they could not fully understand them. In other cases, transactions entered into by government entities have been voided by courts on the grounds that the entity was not empowered to undertake such a transaction.
Settlement risk
The exchange makes sure that the parties to an option transaction comply with their obligations within strict time limits. This is not the case in the over-the-counter market. Central banks in the biggest economies have been trying to speed up the process of settling claims and paying for derivative transactions, but participants are still exposed to the risk that transactions will not be completed promptly. A particular concern is netting, the process by which all of the positions between two counter parties can be set off against each other. Without netting, it is possible that party A will have to make good on its obligations to party B, even though party B is unable to make good on its own obligations to party A. It is not clear whether netting can be legally enforced in all countries, leaving the possibility that a market participant will suffer losses despite having profitable
positions.
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