Understanding derivatives trading (Post 2): A glimpse at derivative market structures
This blog post builds on top of the first post of this series on derivatives. If you haven’t read it yet, check it out here.
If you have read the previous blog post, but need a refresher, here are some of the key points we discussed:
- Trading is all about executing (i.e. signing) contracts and exchanging goods or services as per the legally binding terms of the contract.
- Trading is essential, but it comports risks (e.g. risk that the counterparty does not deliver on the terms of the contract).
- Derivative contracts enable the transfer of various types of risk between risk averse agents (the “hedgers”) and risk seekers (the “speculators”).
- Margin trading allows for better capital efficiency.
- The “trade lifecycle” is:
1. “Execution” (i.e. signature of the contract),
2. “Clearing” (i.e. operational and risk management tasks carried out after “execution” and before “settlement” to “keep the contract active”, e.g. the margin management process etc.), and
3. “Settlement” (i.e. completion of all payments and/or transfers effectively discharging the counterparties from their legal obligations under the contract).
In this blog post, we will dive deeper into the classes of derivative products, look into the structure of these instruments and the associated market structures.
Before proceeding with this blog post, I would like to dare something slightly provocative and probably controversial to many: applying the well known “law of conservation of mass” (i.e. mass can neither be created nor destroyed in a chemical reaction) to risks in financial markets. Our very own “law of conservation of risk” in a sense. As Antoine Lavoisier would say (studying chemical reactions) “nothing is lost, nothing is created, everything is transformed”. The same applies to risks in a given market: “no risk is lost, no risk is created, risk is transformed (and transferred!)”. Risks are never fully removed (in absolute terms — from the system’s standpoint) and are rather transferred from one market participant to another (e.g. using derivatives — remember the “speculator (risk seeker)/business owner (risk averse) symbiosis” we alluded to in the previous blog post).
Of course, such analogy fails to properly model the dynamics of trading derivatives (e.g. practices like netting¹ /portfolio compression and adequate margin/collateral requirements already go a long way towards reducing counterparty risk for instance) and assumes a closed system. We use this analogy as a starting point to specify some goals for anyone designing derivatives trading systems, which are:
- Designing derivative contracts that allow efficient risk transfers among economic agents (i.e. allowing to spread risk “thinly and evenly” across market participants), and
- Designing derivative contracts leading to risk-minimizing market structures (i.e. the means of trading derivative contracts should comport minimal risks)
Finally, as we said, trading comports risks. There is always a possibility that one of the parties involved in a transaction can default on its contractual obligations, effectively breaching the terms of the contract (e.g. default to repay a mortgage, fail to deliver goods after receiving the associated payments etc.). Such possibility is commonly referred to as the counterparty risk, to which we allocate a special attention in this blog post.
When trading derivatives to manage one’s overall risk exposure, one takes some risks off his shoulders while taking on some other risks. Here is an example.
Example: Consider, a business owner — Bob — who is only able to borrow at a floating rate. To achieve a fixed rate, Bob can enter into an Interest Rate Swap (IRS), to effectively “get rid of” risks associated to increasing interest rates. However, by entering into such a transaction, Bob is exposed to “counterparty risk” (i.e. the risk that the other side of the contractual obligation does not fulfill his/her duty as expected). Since Bob is a firm believer that interest rates are doomed to increase and since Bob carried out appropriate due diligence on his counterparty, executing this IRS trade allowed him to re-balance his overall risk exposure by taking what he thinks to be a small risk (i.e. risk that the IRS counterparty defaults) in exchange for offloading what he sees as a big risk for his business (interest rates going up). Bob’s counterparty now bears the risk of increasing interest rates.
I hope this example starts to provide intuition behind our “law of conservation of risk” above. Risks only change hands, and economic agents keep on re-balancing their risk exposures to get rid of (or minimize) risks they are not willing to take.
Now, with all that in mind, let us talk about the different types of existing derivative markets.
Types of derivatives
Exchange traded derivatives (ETDs)
ETDs are derivative contracts that are — as the name indicates — traded on an exchange.
Roughly speaking, the core function of a derivatives exchange is primarily to gather and (orderly and fairly) execute trading intentions of the buyers and the sellers of a given contract. They facilitate the transfer of risks among economic agents by providing mechanisms to enhance liquidity and facilitate price discovery.
Importantly, a variety of elements make up the microstructure of a derivatives exchange (e.g. regulatory oversight, order flow/trade execution, market
making, settlements and clearing, and exchange monitoring to list a few)².
In what follows we will allocate special attention to futures exchanges which generally possess their own clearing houses (CH). As such, these exchanges play the additional role of being the counterparty to all trades. We call such a counterparty a CCP (Central CounterParty).
Remark: As mentioned, each exchange comes with its own structure (i.e. its own market making rules, its own ownership structure, its own pre-trade risk controls³, its own settlement and clearing procedures etc.). As such, the general structure of futures exchanges differs from the general structure of options exchanges for instance (where the Options Clearing Corporation — OCC — generally acts as clearing agent).
ETDs (futures): What we (may) think happens
We know that trading on an exchange consists in sending “orders” which are (unilateral) intentions (“I agree to buy/sell XXX for £Y to anyone willing to take the other side of my trade’’). These are then “matched” and bundled into fully fledged bilateral trading agreements.
As such, an exchange’s order book can simply be treated as two stacks of (anonymous⁴) intention documents. The intentions from the sellers, and the intentions from the buyers. To execute a trade, the exchange reads the terms of the intentions and forms trade agreements from sell/buy intentions with matching terms (i.e. terms that align with one another, e.g. same price, same date, same quantities⁵ etc). That way, sellers and buyers do not need to know each other in advance. They simply rely on the exchange to execute a trade out of their orders when a counterparty deposits a matching intention on the exchange (i.e. “sends an order to the exchange”).
ETDs (futures): What really happens
Matching anonymous buyers and anonymous sellers’ intentions on the exchange isn’t desired though as it means that each party does not know their trade counterparty, which effectively means exposing them to unmeasured counterparty risk. In reality, the futures exchange will position itself in the middle of every trade, acting as the buyer to every seller and the seller to every buyer.
Remark: Exchanges carry out due diligence on their users. Hence, they “know” all their customers, and thus, all their potential counterparties. Exchange’s users (and their customers) may not know each other, however.
What would otherwise be a unique bilateral contract between buyer and seller (see Fig 2 above) is split into two trading agreements (i.e. 2 legally binding contracts, see Fig 3 below), each of which involves the futures exchange.
Over-the-counter (OTC) derivatives
As opposed to ETDs, OTC derivatives are bilateral contracts that are negotiated and traded on a “peer-to-peer” basis on a network of regulated dealers.
Such dealers (e.g. investment banks) act as “risk transfer agents” by making the market.
In general, OTC markets are split into two parts:
- The customer market, where dealers quote prices to their customers and on which bilateral trades happen between dealer and their customer (e.g. individuals or hedge funds).
- The interdealer market, where dealers quote prices to each other and on which bilateral trades happen between a dealer and another dealer (“dealers adjust some of the risks they took off the shoulders of their customers”).
Importantly, in such markets, counterparties trade with one another directly (e.g. by communicating via phone, email, via ATS/MTFs etc.). There is no CCP that guarantees to pay the winning side of the trades (i.e. no exchange or clearing house intermediating).
ISDA®
Dealers in OTC markets typically are banks which are members of the International Swaps and Derivatives Association (ISDA®).
As part of its mission to promote “safe and efficient derivatives markets”⁶, ISDA® created and published a document called ISDA Master Agreement to reduce risk in OTC derivatives trading. More precisely, this agreement is a standard document regularly used to govern the OTC derivatives transactions, which outlines standard terms and standard events of an OTC transaction, and which applies to all future transactions between transacting parties (i.e. no need to start the paper work from scratch all the time).
This master agreement — which comes in two flavors: 1992 (first version) and 2002 (second version, see e.g. here or here for more info) — can then be adjusted via an ISDA Schedule that is used to “customize” the standard terms of the contract.
Overall such standard documentation contributes to improving liquidity, transparency and removing friction in OTC trading (i.e. saves time and legal fees related to drafting contracts, removes obscure provisions that can affect the enforceability of the contract etc.).
OTC reforms
In the aftermath of the global financial crisis (GFC) of 2008–9, increased scrutiny has been allocated to the OTC derivatives market. For many, this market has played a major role in the collapse of the financial system due to its opaqueness, lack of regulation, very low collateral requirements (far too low, at the time, to withstand steep price market movements) and thus over-leverage. These factors, along with the use of complex derivatives contracts whose associated risk profiles were poorly understood, ultimately increased risks in OTC markets and spread out to distress the financial system.
As we know, taxpayer money was ultimately used to inject capital in the private sector, effectively bailing out “too-big-to-fail” companies like AIG, to avoid a domino effect after the collapse of Lehman Brothers in September 2008 (see here and here for more information on the role of OTC derivatives in the financial crisis).
Learning from these events, governments and regulators have worked towards increasing regulations in OTC markets, improve transparency and increase the use of clearing (see, e.g. here). This lead, in September 2009, to the Pittsburgh summit, during which G-20 leaders agreed the following (see here):
All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.
Derivatives characteristics
Characteristics of ETDs
From our high-level description of trading derivatives on exchanges (namely futures), we extract various key characteristics of ETDs.
Not every derivative contract is suitable to be traded on an exchange since sufficient demand is necessary to ensure good liquidity. In general, exchanges list contracts with standardized terms (e.g. futures are generally standardized for quantity, expiry dates, quality — when physical delivery is employed — etc.), which generally provides low latency for trade execution (i.e. large liquidity pool), low fees, etc.
Importantly, when trading via a central limit order book (CLOB), the set of limit orders (i.e. “the stack of buy/sell intentions” sent to the exchange by the buy-side and sell-side of the market) is visible by all market participants. Such an execution model comes with high pre-trade transparency on these markets, but comes at the expense of penalizing certain traders who may want to enter a large trade without disclosing it to the order book⁷.
Characteristics of (non-centrally cleared) OTC derivatives
OTC markets meet an important need for bespoke and exotic contracts tailored for one’s strategy for reducing exposure to risk (i.e. hedging), and which may be traded by very few people (low liquidity/shallow markets). Furthermore, OTC trading allows to trade a wide class of instruments that are not listed on exchanges, and provides an avenue for bilateral negotiation of (potentially very large) contracts⁸. As a consequence of being traded without intermediaries, OTC derivatives have the advantage of providing high pre-trade privacy (the traded contract terms are privy to the counterparties, but the trade information is generally disclosed after the fact in trade repositories). However, such pre-trade privacy comes at the expense of making prices more opaque (no price competition pressure) and opens up the potential for information asymmetries between buyers and sellers of the contracts, effectively increasing the profitability of OTC trades for dealers (who are free to quote different prices on the customer and interdealer markets). Finally, the lack of intermediation in OTC markets provides an avenue for spreading risk more evenly (than in the CCP model) across the various market participants.
Are centrally cleared derivatives the solution?
While clearing OTC trades via a central counterparty clearing arrangement— see Fig 5 above — may provide an avenue for limiting counterparty risk and avoiding risk contagion in derivatives markets, such an approach may increase moral hazard among market participants and has a tendency to increase risk mutualization as well as risk concentration in the CCP which can, in the end, become “too-big-to-fail”⁹. Moreover, increased standardization is generally desired, except when the lack of possibilities to trade bespoke derivative contracts leaves market participants unhedged (which can be very costly) and/or exposes hedgers to basis risk when listed standardized instruments do not adequately correspond to the underlying risk exposure¹⁰.
The CCP model for OTC trading requires to fundamentally re-think the current derivative trading infrastructure to allow non-clearing members to stay involved and able to trade on such markets (see here for more info). Furthermore, transitioning to the CCP model — which means substituting each party’s counterparty by the CCP (e.g. via novation) — effectively builds an “omniscient” agent in the system. While such an approach may be acclaimed as a solution to improve markets’ transparency as well as trade compression and netting (see Fig 6), such argument falls short when studying the view point of non-clearing members. Not only have such members no recourse against the CCP if a clearing member intermediary fails to meet its obligations to its customers, but also have no visibility on the identities and risk exposures of the clearing member’s other customers¹¹.
Now, if we go back to where we started and have another look at our “law of conservation of risk”, we clearly see that trade intermediation via a CCP does not eliminate counterparty risk.
Sure, the perceived risk is reduced. By dealing with a trusted¹² (i.e. honest, competent, financially sound) counterparty, one has the illusion that nothing can knock the counterparty over, and that the counterparty will always meet his obligations w.r.t. the deal. Nevertheless, all of this is a mere mirage and illusion of safety. The world is highly uncertain and no one can perfectly predict the future. Contracts (and trades) are executed within an environment that is mostly outside the control of the counterparties.
Assessing risks is a probability game, and turning to trusted counterparties is not sufficient to yield impossible events! (as recently illustrated by the Archegos meltdown (see e.g. here) or by the bankruptcy of Lehman Brothers in 2008 (see e.g. here) for instance).
Hence, while dealing with trusted counterparties has a tendency to reduce (and even remove) perceived risk, the actual (counterparty) risk still exists¹³. Increasing the gap between perceived and actual risk is undesirable, especially when perceived risk is diminished/removed and actual risk remains untouched, since such scenarios increase market participants’ feeling (i.e. illusion) of safety which can have a tendency to alter agents’ behavior and amplify actual risk, effectively creating a ticking bomb in the system.
Having a CCP as counterparty to all trades surely does not remove counterparty risk. Following our “law of conservation of risk”, we clearly see that, in such model, risk gets concentrated at one place. While cleared markets seem more robust at times of moderate troubles (the CCP can do some netting to reduce settlement risk, the CCP is regulated, is supposed to be well funded etc), it remains to be shown how resilient would a market be in the event where the CCP could default (i.e. could the CCP model amplify systemic risk?). In fact, we should remember that the CCP’s loss absorption is limited. The default fund balance of a CCP roughly corresponds to the sum of the clearing member’s contributions, plus the CCP’s contribution — known as “CCP skin in the game” (CCP SITG) (see here for more information).
By its very nature of “counterparty to all trades”, it seems unavoidable that taxpayer money would need to be used to bail out such systemic actors if the default fund was to be drained.
Conclusion
In a system where risks are everywhere, derivative contracts allow economic agents to re-balance their risk exposure to fit their needs.
Out of these contracts, ETDs and uncleared OTC derivatives are at extremes ends of the derivatives spectrum. As we have seen, both classes of contracts can be traded in different ways, providing different sets of tradeoffs and meeting different needs. After the GFC, governments and regulators charged the Financial Stability Board (FSB) with the mission to provide recommendations on and monitor the implementation of the G-20 objectives that reformed the OTC market. Such objectives consisted in using more centrally cleared derivative contracts to improve market transparency and mitigate counterparty risk. Nevertheless, the improvements of the CCP model are still to be considered. Market transparency is generally considered a good thing, but pre-trade transparency is not always desired. Likewise, the risk mutualization and concentration tendency of this model raise doubts w.r.t. its potential to exacerbate systemic risk. Nevertheless, such topic remains a research area as of today.
Instead of relying on CCPs to contain counterparty risk, couldn’t we simply rely on trade compression along with better collateral requirements and management techniques? Maybe one to expend in a future blog post…
Appendix. A new emerging class of derivative markets: blockchain-traded derivatives?
A new class of derivatives products are emerging on blockchain systems. While such products can be traded through different venues (e.g. via Central Limit Order Books (CLOB), Request for Quotes (RFQ) etc. — echoing current market structures, where the blockchain generally acts as settlement leg — , or virtual Automated Marker Makers (AMM) — where “execution is settlement”), the space of “blockchain derivatives” keeps on moving and mutating at an astounding pace, begging for more market structure research in this area. As of today, lots of similarities exist between “traditional finance” and “decentralized finance” market structures¹⁴, and the space of “blockchain derivatives” does not seem immune to this. Some crypto-exchanges (centralized or decentralized) offering derivatives products are systems designed around the notion of an “insurance fund” which acts as “payer of last resort” if losing positions get liquidated too late — which greatly echoes the role of a CCP exposed above in this post. The microstucture of crypto-exchanges (centralized or decentralized) is ever evolving, especially as new protocol upgrades are implemented (e.g. move from PoW to PoS, liquid staking etc.). More studies on the structure of crypto-markets will be needed in the future once the space settles, and we have more perspective on crypto-derivatives projects.
All in all, studying the structures of various markets and trading venues allows to assess the risk-associated to specific trading systems. Likewise, understanding the rationale behind existing market structures and their limitations is paramount to hope to improve on the status quo and design more efficient, fair and resilient financial markets.
Footnotes
[1]: Netting is a process that reduces multiple obligations with various
counterparties to a single (or fewer) obligation(s). Bilateral netting, for instance, consists in merging all traded contracts between 2 parties into a single net position requiring one party to pay the other (e.g. if Alice owes £2 to Bob and Bob owes £5 to Alice, after netting, Bob owes £3 to Alice).
[2]: See “The Structure of Derivatives Exchanges: Lessons from
Developed and Emerging Markets” by George Tsetsekos and Panos Varangis (1997) for more information on derivatives exchanges.
[3]: See “How Do Exchanges Control the Risks of High Speed Trading?” by Carol Clark and Rajeev Ranjan (November 2011) for more details.
[4]: The originator of an order is not disclosed in the order book.
[5]: In practice, and depending on the assets traded, trade execution details such as “partial fills” need to be considered when implementing an order book.
[6]: See ISDA®’s mission statement.
ISDA® is a registered trademark. Clearmatics is not sponsored by or affiliated with ISDA.
[7]: Assume you are a trader with deep pockets, and as a good trader, you monitor the news in search for an event that may affect the price of the asset you are willing to trade. Luckily, your favorite news aggregator just published a piece of information that you think will push the price of an asset up. Thus, you send a large BUY limit order on the CLOB in the hope of entering the market at a good price, and capturing the upswing by selling higher when the news you read propagates to all the market. Unfortunately, your large BUY order is added to the CLOB and everyone can see your large “buying intention” at the limit price specified. By trading via a CLOB, you accelerated the information propagation of the news in the market and exposed your trades intentions before these could be matched and executed, effectively decreasing your chances to make a profit on this trade.
[8]: “Customized” derivative contracts are very powerful risk-management tool and essential to develop robust hedging strategies.
[9]: Although, the CCP is regulated, generally well funded and governed, carries out netting and runs elaborated risk assessment routines. See, e.g. here and here for more information.
[10]: Roughly speaking, basis risk is the risk exposure resulting from imperfect hedge.
[11]: See “OTC derivatives — A primer on market infrastructure and regulatory policy”, by I. Ruffini and R.S. Steigerwald, for more information.
[12]: As argued by Francis Fukuyama in his book Trust: The Social Virtues and The Creation of Prosperity, trust is a building block of a nation’s wealth. People who do not trust each other end up cooperating only under a system of formal rules and regulations, which have to be negotiated. As such, widespread distrust in a society imposes a tax on all forms of economic activity. On the other hand, trust facilitates cooperation and removes friction in trading. However, trust arises when a community shares a set of moral values in such a way as to create expectations of regular and honest behavior. While operating in a fully “trustless” fashion is not desirable (trust removes friction, facilitates trading and contributes to prosperity), it is however legitimate to think about the “object of trust”. Instead of relying on trust between trading counterparties, which is subject to common traditions and values, and builds over time; trust may instead be embodied in the trading methods and protocols used by trade counterparties (e.g. a blockchain as an anchor of trust — provided that trade counterparties are sufficiently educated about the underlying technology).
[13]: See Systemic Research Center magazine for more information on the notions of perceived risk vs actual risk.
[14]: Parallels can be drawn between the decentralized finance ecosystem and existing “traditional” markets (e.g. insurance fund for DEXes vs default funds in CCPs, miners & MEV vs marker makers & PFOF, “partnership with miners for fast transaction inclusion” vs “partnerships between sell and buy-side firms for Direct Market Access (DMA)”, crypto custodians becoming banks, similarities in exchanges (crypto and non-crypto) microstructures etc etc.)
Acknowledgements
Thanks to Robert Sams for reviewing and providing feedback on previous versions of this post. Thanks to Max Croasdale for flagging a few typos and grammatical mistakes in an earlier version of this post.
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