2.1 INTRODUCTION
Derivatives transactions represent contractual agreements either to make payments or to buy or sell an underlying security at a time or times in the future. The times may range from a few weeks or months (for example, futures contracts) to many years (for example, long-dated swaps). The value of a derivative will change with the level of one or more underlying assets or indices and possibly decisions made by the parties to the contract. In many cases, the initial value of a traded derivative will be contractually configured to be zero for both parties at inception.
Derivatives are not a particularly new financial innovation; for example, in medieval times, forward contracts were popular in Europe. However, derivatives products and markets have become particularly large and complex in the last three decades. One of the advantages of derivatives is that they can provide very efficient hedging tools. For example, consider the following risks that an institution, such as a corporate, may experience:
- Interest rate risk. They need to manage liabilities such as transforming floating- into fixed-rate debt via an interest rate swap.
- Foreign exchange (FX) risk. Due to being paid in various currencies, there is a need to hedge cash inflow in these currencies, for example, using FX forwards.
- Commodity risk. The need to lock in commodity prices either due to consumption (e.g. airline fuel costs) or production (e.g. a mining company) via commodity futures or swaps.
In many ways, derivatives are no different from the underlying cash instruments. They simply allow one to take a very similar position in a synthetic way. For example, an airline wanting to reduce its exposure to a potential rise in oil price can buy oil futures, which are cash-settled and therefore represent a very simple way to go ‘long oil’ (with no storage or transport costs). An institution wanting to reduce its exposure to a certain asset can do so via a derivative contract (such as a total return swap), which means it does not have to sell the asset directly in the market.
There are many different users of derivatives such as sovereigns, central banks, regional/local authorities, hedge funds, asset managers, pension funds, insurance companies, and non-financial corporations. All use derivatives as part of their investment strategy or to hedge the risks they face from their business activities. Due to the particular hedging needs of institutions and related issues, such as accounting, many derivatives are relatively bespoke. For example, a corporation wanting to hedge the interest rate risk in a floating-rate loan will want an interest rate swap precisely matching the terms of the loan (e.g. maturity, payment frequency, and reference rate).
Financial institutions, mainly banks, provide derivative contracts to their end user clients and hedge their risks with one another. Whilst many financial institutions trade derivatives, many markets are dominated by a relatively small number of large counterparties (often known as ‘dealers’). Such dealers represent key nodes of the financial system. For example, there are currently around 35 globally-systemically-important banks (G-SIBs), which is a term loosely synonymous with ‘too big to fail’. G-SIB banks are subject to stricter rules, such as higher minimum capital requirements.
During the lifetime of a derivatives contract, the two counterparties have claims against each other, such as in the form of cash flows that evolve as a function of underlying assets and market conditions. Derivatives transactions create counterparty credit risk (counterparty risk) due to the risk of insolvency of one party. Counterparty risk refers to the possibility that a counterparty may not meet its contractual requirements under the contract when they become due.
Counterparty risk is managed over time through clearing; this can be performed bilaterally, where each counterparty manages the risk of the other, or centrally through a central counterparty (CCP). As the ...
