The derivatives market is a complex arena. But understanding how it works can help you make better investment decisions.
Before the 2008 financial crisis, the bankruptcy code included special exemptions from core bankruptcy provisions for derivative and repo users, which distorted markets by giving them preferred positions. This must change.
Definitions
Derivatives are financial instruments whose value is derived from an underlying asset. Investors use derivatives to manage risk, speculate, or gain leverage. They’re often bought and sold on a centralized exchange (exchange-traded derivatives, or ETDs) or over the counter (OTC), meaning they’re negotiated privately between two parties.
For example, a company with a variable interest rate loan could swap that loan to a fixed interest rate for a fee, reducing its exposure to rising interest rates. That’s an example of a derivative used for risk management, or “hedging.”
On the other hand, someone who buys oil futures contracts to protect against a rise in oil prices is using them for speculation – making a financial bet. Because they rely on the performance of an underlying asset, derivatives are often highly volatile and fast-moving. They can be extremely profitable to traders but also make them vulnerable to market disruptions and cause significant losses for shareholders or investors.
The clue is in the name: derivatives derive their value from an underlying asset, like a commodity, stock, or currency. Traders can create products for anything, but they’re most commonly used for assets like stocks, bonds, currencies, and interest rates. Most derivatives are traded OTC and can be endlessly customized for specific needs.
Regulation
A derivatives lawyer should know with will occasionally encounter an issue involving derivatives and the regulations issued by the Commodity Futures Trading Commission. While many derivatives are traded on regulated exchanges, others are not; over-the-counter (OTC) are negotiated between private parties, exposing their users to much greater risk.
A simple example of an OTC derivative is an interest rate swap between a bank and a company to transform future loan interest payments from fixed rates to variable ones. Banks use these to hedge against changes in interest rates; mortgage lenders can also use them in connection with real estate loans.
Even OTC derivatives that the CFTC does not regulate may be subject to federal law, particularly the bankruptcy code, which contains special exemptions for derivatives and repos. These exemptions distorted credit market conditions leading up to the 2008 crisis. They gave derivative and repo users preferential positions in bankruptcy on the false theory that such special protection would prevent systemic financial problems.
Bringing derivatives under the purview of one or more existing federal regulators rather than under the CFTC’s exclusive jurisdiction could bring more market discipline and less taxpayer-backed bailout to the financial markets. This might reduce the need for complex and burdensome rules, such as a leverage ratio that accounts for derivatives exposure in a transparent manner.
Origins
Derivatives are financial instruments that derive value from the underlying asset, such as a stock, commodity, or interest rate. They can be exchange-traded, like futures contracts traded on the Chicago Mercantile Exchange (CME), or over the counter, such as options negotiated between two parties.
OTC derivatives are more risky because they lack the benefit of a central clearinghouse that monitors the financial wherewithal of each party to ensure it will be able to fulfill its end of the bargain. This is known as counterparty risk.
Investors and companies use derivatives to mitigate or assume risk with a commensurate reward. Moving too much risk from the risk-averse to the risk seekers can cause significant losses for corporations, individuals, and the overall economy, as the subprime mortgage crisis of 2007 to 2008 demonstrated.
A key factor was that regulators needed to correctly identify the risks of speculative derivatives or protect against them. A recommended change is for the regulatory framework to stop treating derivatives as unique products and instead rely on broader rules that foster accurate disclosure of information by all users of financial markets.
The 2010 Dodd-Frank Act significantly strides in this direction, but many other changes are needed. For example, the special exemptions from bankruptcy code provisions that have long been granted to derivative and repo users should be removed.
Types
The financial derivatives market offers many products that can fit any risk tolerance. They are often used for risk management, speculation, or to leverage a position. They can be exchange-traded, standardized contracts traded on an organized futures exchange or over-the-counter (OTC) and negotiated privately between two parties. They include various products such as futures, forwards, swaps, and options.
In general, a derivative’s value is derived from its underlying asset. For example, an oil futures contract is based on the price of crude oil, while a stock option is based on the price of a company’s shares. Derivatives are also popular hedging instruments, as they can help reduce the risk of future exposure or financial market volatility.
However, because they are based on existing securities, they have the same counterparty risk as other investments. Traders may use the same derivative contract with different counterparties, increasing the potential for credit problems if one of the parties becomes insolvent.
To help reduce this risk, standardized stock options by law require the party at risk to have a deposit with an exchange, showing that they can pay for losses; banks that help businesses swap variable interest rates on loans often do credit checks on both parties; and other forms of collateral may be required in private agreements between traders.
