9.7 Derivative markets

Question 1

What is the main derivatives exchange in the UK?

Answer 1

ICE Futures Europe

Question 2

List 4 things ICE Futures offers

Answer 2

1. Contracts on financial assets
2. Energy products
3. Agricultural products
4. Softs

Question 3

Which regulator is ICE Futures Europe recognised by?

Answer 3

The FCA

Question 4

How can one trade on ICE Futures Europe?

Answer 4

Trading can only be conducted by, or through, members of the exchange.

Question 5

Which clearing house does ICE Futures Europe use and for what?

Answer 5

• ICE Futures Europe uses ICE Clear Europe (a clearing house recognised by the Bank of England) to clear, register and arrange settlement on its contracts.

Question 6

How can member firms of derivative exchanges act?

Answer 6

Like equity and debt markets, member firms of derivative exchanges may act either as principal to a trade and/or as agent.

Question 7

Explain dealing (principal trades).

Answer 7

By acting as principal, the firm is taking a position itself, i.e. ‘running a book’. The aim is to make a turn on the trade (buy low, sell high). When acting as principal, the trade will be assigned to the firm’s house account. These traders are sometimes referred to as ‘locals’.

Question 8

Explain broking (agency trades).

Answer 8

The firm may act as agent on behalf of a client. In these circumstances, the firm will not take a position but instead earns commission on the trade. When acting as agent, the trade will usually be assigned to a segregated account which is separate from the firm’s own account. Some clients may, however, consent to their trades being allocated to a non-segregated account.

Question 9

What happens when some members of an exchange execute a trade for other members of an exchange?

Answer 9

These trades will usually be allocated, or ‘given up’ to the house account of the originating firm. A trade is ‘given up’ so that the originating firm can clear the trade on behalf of the client.

Question 10

What is meant by the term dual capacity?

Answer 10

Members that can act as either agent or principal to a trade, are said to have dual capacity.

Question 11

Where does the term open outcry trading stem from? Can you name a market where open outcry trading still takes place?

Answer 11

Historically, most derivatives trading took place face-to-face on a market floor. Traders gathered in pits and ‘cried’ out prices, hence the term open outcry trading. The London Metal Exchange (LME) is a market where open outcry trading still takes place.

Question 12

What form of trading have derivative exchanges tended to move towards?

Answer 12

Rather like the securities markets, derivative exchanges have tended to move towards screen-based order book trading. Trading takes place electronically based on prices displayed on screens

Question 13

Do you need an exchange floor for screen-based order book trading?

Answer 13

There is no requirement for an exchange floor as trading takes place remotely via computers. ICE Futures Europe uses such an order driven system.

Question 14

How does execution occur on derivative exchanges that use screen-based order book trading?

Answer 14

Execution occurs in very much the same way as we say on the LSE SETS.

Question 15

Explain the legal side of trading derivatives.

Answer 15

When trading derivatives, the participants are entering into legally binding contracts to perform an action (make or take delivery of an asset) at some point in the future. To ensure the contracts are legally binding, the exchange will construct the contract that is agreed. To ensure the maximum liquidity, the exchange will standardise these contracts; this means every member is trading an equivalent contract within an underlying asset class.

Question 16

Derivative exchanges set down rules that dictate the requirements of members. What is the main rule?

Answer 16

Requirements on reporting trades.

Question 17

Define over-the-counter (OTC) contracts.

Answer 17

Over-the-counter (OTC) contracts are one-to-one (bilateral) agreements between two counterparties where the contract specifications are completely flexible and non-standardised.

Question 18

What is a great benefit of over-the-counter (OTC) contracts?

Answer 18

A great benefit of this is that, when hedging, the contract used can be specifically tailored to the requirements of the underlying position, whereas when using standardised exchange-traded contracts hedges need to be continually rebalanced or rolled on from month to month.

Question 19

How are OTC deals conducted?

Answer 19

OTC deals are not conducted on a formal exchange, but directly via telephone and screen-based displays. There is less likelihood of a central guarantor (like LCH.Clearnet or ICE Clear Europe) to ensure ultimate fulfilment of the contract, so the creditworthiness of both counterparties is extremely important.

Question 20

What requirements are OTC trades subjected and not subjected to?

Answer 20

OTC trades are not subject to the MiFID pre-trade and post-trade transparency requirements. However, there is some requirement to make reports. This was most notably enforced in Europe under the European Markets and Infrastructure Regulation (EMIR).

Question 21

What are some difficulties associated with OTC contracts?

Answer 21

Because OTC contracts are tailor-made, they are more difficult to trade than exchange-traded contracts. This also makes them difficult to value, and price information is not always available.

Question 22

Why do OTC contracts also require substantial documentation?

Answer 22

To ensure that the terms of each contract are clear, accurate and agreeable to both sides of the trade.

Question 23

What is the role of the International Swaps and Derivatives Association (ISDA)?

Answer 23

To oversee the OTC derivatives market and produce standardised formats on which OTC documentation can be based.

Question 24

What is the benefit of an OTC?

Answer 24

They are a product that can be designed to meet the exact requirements of market participants.

Question 25

Summarise the difference between OTC and Exchange Traded products in regards to: * Contract terms * Liquidity * Margin * Regulation * Counterparty Risk * Reporting * Price * Hedging

Answer 25

**OTC** **Traded on exchange** Contract termsBespoke: Tailored to meet the needs of the investorContract specifications standardised by the exchangeLiquidity Can be limited leading to slower execution Excellent on majorcontractsMargin Normally no margin Collateral process Margin normally requiredRegulation Less stringent regulation of products More stringent restrictions on who may invest in them Exchanges subject to significant regulation Counterparty risk Typically exposed to default risk No member default riskdue toclearing house Reporting Confidentiality Market transparency Price Negotiated or request for quote (RFQ) systems Best execution Hedging Specific hedging requirements can be met Hedges based on standardised contracts need to be actively managed

Question 26

Summarise the difference between OTC and Exchange Traded products in regards to: * Contract terms * Liquidity * Margin * Regulation * Counterparty Risk * Reporting * Price * Hedging

Answer 26

Here is a summary of OTC contracts: * The contract terms are bespoke as they are tailored to meet the needs of the investor. * The liquidity can be limited leading to slower execution. * There is normally no margin, it's a collateral process. * There is less stringent regulation of products and more stringent restrictions on who may invest in them. * Counterparty risk: typically exposed to default risk. * The reporting is confidential. * The price is negotiated or request for quote (RFQ) systems used. * Specific hedging requirements can be met. Here is a summary of exchange-traded contracts: * The contract specifications are standardised by the exchange. * The liquidity is excellent on major contracts. * Margin is normally required. * Exchanges are subject to significant regulation. * Counterparty risk: no member default risk due to clearing house. * There is market transparency in reporting. * The best execution price is used. * Hedges based on standardised contracts need to be actively managed.

Question 27

How are OTC trades typically conducted and what is the benefit of this approach?

Answer 27

OTC trades are typically done bilaterally between two parties who negotiate and agree terms with each other. This eliminates the need for an exchange, potentially lowering the cost and giving much more flexibility in what details can be written into the contract.

Question 28

What is one of the major disadvantages of OTC contracts?

Answer 28

One of the major disadvantages of OTC contracts is not having access to an exchange’s risk management systems, such as the clearing house and its margining and settlement systems.

Question 29

What have regulators tried to improve in OTC contracts?

Answer 29

There has been a great effort in recent years by regulators to improve **risk management** in the OTC market.

Question 30

What 3 new requirements does the European Markets Infrastructure Regulation (EMIR) impose on those who trade OTC derivatives and who do they apply to?

Answer 30

1. To clear OTC derivatives that have been declared subject to the clearing regulation through a central counterparty (CCP) - The Public Register for the Clearing Obligation identifies the classes of OTC derivatives that central counterparties are authorised to clear 2. To put in place risk management procedures for those OTC derivatives that are not centrally cleared 3. To report derivatives to a trade repository - Repositories include the DTCC Derivatives Repository and Bloomberg Trade Repository All three obligations apply to financial counterparties.

Question 31

The clearing and risk management obligations apply, in addition, to certain non-financial counterparties who are above clearing thresholds. What are these thresholds?

Answer 31

* €1bn in gross notional value for OTC credit derivative contracts * €1bn in gross notional value for OTC equity derivative contracts * €3b in gross notional value for OTC interest rate derivative contracts * €3bn in gross notional value for OTC foreign exchange derivative contracts * €3bn in gross notional value for OTC commodity derivative contracts and other OTC derivative contracts not defined in the earlier 4 requirements.

Question 32

Who do the reporting obligations apply to?

Answer 32

The reporting obligation applies to all participants.

Question 33

What is the rule for trades that are captured by mandatory clearing or are reported to a repository?

Answer 33

Trades that are captured by mandatory clearing or are reported to a repository must also meet **post-trade disclosure obligations.** These are met by publishing trade details through an **Approved Publication Arrangement.**

Question 34

What has happened to EMIR in the UK post-Brexit?

Answer 34

Following Brexit, the UK has onshored EMIR, known as UK EMIR. While most of the obligations under UK EMIR are substantively the same as those under EU EMIR, there are a few exceptions. These include **reporting derivative transactions** entered into **on or after 1 January 2021** to one of the following **trade repositories** authorised and registered under UK EMIR: ICE Trade Vault Europe Limited, UnaVista Limited, DTCC Derivatives Repository Plc or REGIS-TR UK Limited.

Question 35

Which body is responsible for the registration and supervision of trade repositories?

Answer 35

FCA

Question 36

What derivative regulation is in the US?

Answer 36

In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010, building on the Commodities Exchange Act 1936 and the Commodity Futures Modernisation Act 2000, imposes similar requirements. These will be enforced by the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC).

Question 37

What is the International Financial Reporting Standards (IFRS 9)?

Answer 37

IFRS 9 replaces IAS 39, and dictates how financial instruments, such as **derivatives**, are **valued** and **recognised** in the company’s **financial statements**. This is particularly relevant to derivatives as, particularly in the case of futures, there is no initial outlay involved.

Question 38

Explain what is meant by the term ‘**Fair value through profit and loss**’

Answer 38

Derivatives, and investments with embedded derivatives, should be recognised at fair value, with changes in fair value recognised through profit or loss in the reserves. In this way they are marked-to- market at the time of producing the financial statements and any profit or loss is recognised appropriately