Exchanges and OTC Markets

After completing this reading, you should be able to:

• Describe how exchanges can be used to alleviate counterparty risk.
• Explain the developments in clearing that reduce risk.
• Describe netting and describe a netting process.
• Describe the implementation of a margining process and explain the determinants of initial and variation margin requirements.
• Compare exchange-traded and OTC markets and describe their uses.
• Identify the classes of derivative securities and explain the risk associated with them.
• Identify risks associated with OTC markets and explain how these risks can be mitigated.
• Describe the role of collateralization in the over-the-counter market and compare it to the margining system.
• Explain the use of special purpose vehicles (SPVs) in the OTC derivatives market.

Exchanges and Counterparty Risk

a. Describe how exchanges can be used to alleviate counterparty risk.

One way to reduce counterparty risk is through the use of exchanges. An exchange is a platform that allows two parties to trade assets in a safe and efficient manner, including standardized futures, options, and other derivatives contracts. By using an exchange, both parties can be confident that they will receive the asset they are expecting. In addition, exchanges typically require both parties to post collateral, which helps to further reduce the risk of default. As a result, exchanging assets is an effective way to mitigate counterparty risk.

Clearing

b. Explain the developments in clearing that reduce risk.

Clearing is the process of settling a derivatives trade. Several developments in the clearing process have been credited for reducing counterparty risk. These include netting, margining, and the presence of central counterparties (CCPs).

Central Counterparty (Clearinghouse)

After both parties have agreed to the terms of the trade, they notify their clearinghouses. The clearinghouse then steps in as the buyer to every seller and the seller to every buyer. This way, if one party defaults on their obligation, the other party is still protected. The clearinghouse acts as a central counterparty, guaranteeing all trades and ensuring that they are settled in a timely manner. In order to offset the risk of default, clearinghouses require participants to post collateral. This collateral can take the form of cash, securities, or other assets. CCPs are an important part of the derivatives market and help ensure the smooth functioning of financial markets.

Example 1

Assume that traders A and B are in a contract to transact at a later date, with A as the seller and B as the buyer. The CCP will act as a central party to both A and B. A will sell to the CCP the agreed item at the agreed price. B will then buy the item from the CCP at the agreed price.

A derivatives market can function without a CCP, but there are several advantages to using one. First, CCPs help to reduce counterparty risk by becoming the sole counterparty to each trade. This means that if one party defaults on its obligations, the other party will still be able to receive the full value of its contract. second, CCPs help to promote market liquidity by providing a ready source of buyers and sellers for each contract. This is especially important in times of market turbulence, when many traders may be reluctant to enter into new positions. Finally, CCPs can help to standardize contracts and promote greater transparency in the market. This can make it easier for market participants to price risk and make informed investment decisions. 

The other ways in which CCPs handle counterparty risk include:

1. Netting
2. Variation Margin and Daily Settlement
3. Initial Margin
4. Default Fund Contributions

Netting

c. Define netting and describe a netting process.

Netting is the process of offsetting positions between counterparties in order to reduce counterparty risk. This is done by creating a single, combined contract that cancels out the individual contracts. For example, if Party A has a long position in ABC stock and Party B has a short position in the same stock, they can net their positions so that they are only exposed to the difference between the two prices. This is done by agreeing to an arrangement where any gains or losses are settled between the two parties on a daily basis. This type of arrangement is known as a “daily mark-to-market” or DMM.

Example 2

Two investors have two different contracts. In contact #1, Investor A owes $50,000 to Investor B. In contract #2, Investor B owes $100,000 to Investor A. Let’s assume that the settlement date of both transactions, as well as the settlement currency, are the same. Instead of Investor A and B making two separate payments to each other, the transaction values can be netted. In a netting agreement, Investor B would pay $50,000 (net amount) to Investor A, whereas Investor A does not need to pay anything to Investor B.

Example 3

Assume that Member X shorts five September oil contracts. At about the same time, Member X makes another trade in which it agrees to buy 10 September oil contracts. Even though the CCP member will now have two separate trades with the CCP, the two will be collapsed to a net long position of five September oil contracts (i.e., contracts to buy 5,000 barrels of oil in September).

Netting can be an extremely effective way for companies to streamline their payment processes and reduce costs. By consolidating all of their transactions into a single payment, they can eliminate the need to process a large number of individual transactions each month. This can save a significant amount of time and money, especially for banks that transfer funds across borders. In addition, by reducing the number of foreign exchange transactions, netting can also help to reduce risk.

Netting can be used to offset exposures in multiple ways, including but not limited to bilateral netting, multilateral netting, novation netting, and close-out netting. Netting agreements are typically governed by legal documentation that outlines the terms and conditions of the agreement. This documentation is important in ensuring that both parties understand their rights and obligations under the agreement.

Margining

d. Describe the implementation of a margining process by central counterparty (CCP); explain the
determinants of and calculate initial and variation margin requirements

Margining is the process of securing or collateralizing a derivative contract with cash or other assets. This ensures that both parties to the contract fulfill their obligations. The initial margin is the amount of collateral required to open a position, and the maintenance margin is the minimum amount that must be maintained in order to keep the position open. In derivatives markets, margining is typically done on a daily basis, meaning that each day, both parties must post collateral equal to the Mark-to-Market value of the contract. If the value of the contract has increased, one party will post collateral to the other party. If the value of the contract has decreased, the reverse will happen. This system helps to ensure that both parties have adequate collateral at all times and reduces the risk of default.

Example 4

Suppose that trader A enters four June futures contract to sell 1000 barrels of oil. Suppose further that June futures price is 300 cents per barrel at the close of trading on Day 1 and 275 cents per barrel at the close of Day 2.

Trader A has lost

$$1000\times(300-275) \quad \text{cents} =\text{25,000 cents or USD 250}$$

The trader is thus required to pay USD 250 to the CCP.

If June futures price is 310 cents per barrel at the close of Day 3, however,

Trader A has gained

$$1000\times(310-275) \quad \text{cents} =\text{35,000 cents or USD 350}$$

The CCP is thus required to pay the trader, USD 350.

The initial margin amount is set by the CCP and is dependent on the changes in the future market prices. The CCP is therefore allowed to alter the initial margin at any point depending on market changes.

CCPs do not pay interest on variation margins because futures contracts are settled daily. It is true, however, that CCPs pay interest on initial margin because it is owned by the member who contributed it. In the event that the interest rate paid by the CCP is deemed unsatisfactory, securities such as Treasury bills may be posted by members instead of cash. As a result, the CCP would reduce the value of the security by a certain percentage in order to determine their cash margin equivalence. The reduction is known as a haircut. When the price volatility of an asset increases, a haircut is usually increased

Default Fund Contributions

In the derivative market, the default fund is the pot of money that is used to cover the losses of a party that defaults on its obligations. The size of the default fund is typically determined by the rules of the exchange or clearinghouse. For example, in the case of CME Group’s credit event binary options, the default fund consists of contributions from all participants in the market. 

The default fund contribution is calculated as a percentage of the notional value of the contract and is typically between 0.1% and 0.5%. The size of the default fund contribution is often determined by the creditworthiness of the contracting parties. For example, if one party is judged to be much more likely to default than the other, then that party will be required to make a larger contribution to the default fund.

The purpose of the default fund is to protect against loss in the event of a default and to provide liquidity in the market so that trading can continue in cases where one or more participants are unable to meet their obligations. 

Uses of Margin Accounts in Other Situations

A margin account can be used between a trader and a broker. If the broker is not a member of a CCP, it will have to use an entity that is a member giving rise to a margin account between the broker and the member.

Unlike margin accounts between CCPs and their members, a margin account between a broker and a retail trader comprises both an initial and a maintenance margin.

The balance in the margin account should not fall below the maintenance margin.

Options on Stocks

To hedge against future liabilities, traders with short positions in an option need to post margin with CCPs.

Calculating Margin for an Option

The margin on a short call option is the maximum between the following  two values:

• 100% of the value of the option + 20% of the share price minus the  amount the option is out of money, if any; or
• 100% of the value of the option + 10% of the share price

The margin on a short put option is the maximum between the following two values:

• 100% of the value of the option + 20% of the share price minus the amount the option is out of money, if any; or
• 100% of the value of the option + 10% of the strike price

Short Sales

Short stocks are stocks that are borrowed and sold and thereafter repurchased and returned to the account they were borrowed from.

To short a stock, a margin of 150% at the time of the trade is required. The margin account varies with stock price changes. If stock prices increase, the margin account reduces, and vice versa.

A trader who would like to trade 1000 shares with a stock price of $20 per share would be needed to first post an initial margin of 150% × 20,000 = 30,000. The proceeds from the sale ($20,000) belong to the trader, while the additional $10,000 is the margin account.

Note that the margin account still belongs to the trader. It is payable plus interests on the balance. However, if prices increase beyond the margin account, the position is closed out.

Buying Stocks on Margin

e. Describe process of buying stock on margin without using CCP and calculate margin requirements.

When an investor wants to trade securities in a margin account, the broker-dealer will lend them a certain percentage of the purchase price of the security, with the investor borrowing the remainder. The initial margin is the minimum percentage of the trade cost that must be provided by the trader at the time of the trade. The maintenance margin is the minimum percentage of the total value of the contract that must be maintained in the account to keep the position open. This margin is intended to protect brokers and their clients from large losses in the event of a market downturn. If the value of the securities in the margin account falls below this minimum, the investor will be required to deposit more money or securities in order to bring the account back up to the maintenance margin. 

In most cases, the initial margin is 50%, and the maintenance margin is 25%. Both are calculated as a percentage of the value of the shares purchased. For example, if an investor wants to buy $10,000 worth of XYZ stock and the initial margin is 50%, the broker-dealer will lend $5,000, and the investor will need to put up $5,000 of their own money. The maintenance margin would be $2,500.

To see how buying on margin works, let’s assume that on Day 1, the value of the stocks decreases to $7,800. As such, the balance in the margin account falls to USD 2,800 (i.e., $5,000 – $2,200). The margin as a percentage of the (current) value of the shares purchased is around 36% (= 2,800/7,800). Since this is more than 25%, there is no margin call. 

On Day 2, the value of the stocks further decreases to $6,000. As such, the balance in the margin account falls to USD 1,000 (i.e., $5,000 – $4,000). The margin as a percentage of the value of the shares purchased is around 17% (= 1,000/6,000). Since this is less than 25%, there is a margin call to bring the margin balance up to 25% of the value of the shares. To do this, the trader must add $500 (= 25% X $6,000 — $1,000) to the margin balance. If it is not provided, contract termination agreements in the contract may give the broker the right to sell the shares.

There are several important things to remember about margins. First, when an investor buys securities on margin, they are borrowing money from their broker-dealer, and they will be required to pay interest on that loan. Second, if an investor does not maintain their account at or above the minimum maintenance margin requirements, their broker-dealer can sell some or all of their securities without notification in order to bring the account back up to minimum margins. Finally, it’s important to remember that margins are not a free lunch – investors are taking on additional risk by trading on margin, and their potential losses are magnified.

Over-the-Counter Trading vs. Exchange Trading

f. Compare exchange-traded and OTC markets and describe their uses

The over-the-counter market is a decentralized trading platform without a central physical location, where market participants use a host of communication channels to trade with one another without a formal set of regulations. The communication channels commonly used include telephone, email, and computers. OTC trading is facilitated by a derivatives dealer, who usually is a major financial institution specializing in derivatives. Participants in an OTC Market are either dealers or end-users. Dealers enter into derivative transactions in a bid to satisfy end users.

In an OTC market, it’s possible for two participants to exchange products/securities privately without others being aware of the terms, including the price. OTC markets are much less transparent than exchange trading. Since the derivatives are not standardized, they can be customized to meet the needs of the end user.

Stocks traded in an OTC market could belong to a small company that’s yet to satisfy the conditions for listing on the exchange. The OTC market is also popular for large trades.

Now that you know the basics of each type of market, let’s take a more in-depth look at the key differences between exchange-traded and OTC markets:

Regulation

As we mentioned before, exchange-traded markets are highly regulated by central authorities like stock exchanges. This regulation provides greater transparency and order in these types of markets. On the other hand, OTC markets are much less regulated, which can make them more volatile but also more flexible.

Flexibility

Because they are less regulated, OTC markets offer more flexibility than exchange-traded markets. In an OTC market, parties can trade almost anything they want. This includes stocks that are not listed on formal exchanges. Exchange-traded markets, on the other hand, are limited to stocks that are listed on a particular exchange.

Volume

Another key difference between these two types of markets is volume. Exchange-traded markets often see higher volumes than OTC markets because they are generally larger and have more participants. This means that there is usually more liquidity in exchange-traded markets, which can be beneficial for traders looking to buy or sell large quantities of securities quickly.

Price discovery

Price discovery is the process by which traders determine the prices of securities in the market. In general, prices in exchange-traded markets are discovered through auction mechanisms like bidding or offering prices. On the other hand, prices in OTCmarkets are typically discovered through dealer networks where parties negotiate prices between themselves without going through a formal auction process.

Trading hours

One final difference to keep in mind is trading hours. Exchange-traded markets usually have fixed trading hours (e., 9:30 AM – 4:00 PM EST), while OTC markets do not have set trading hours, and trades can occur 24/7

Advantages of OTC Markets over Exchanges

• There are fewer restrictions and regulations on trades.
• The participants have the freedom to negotiate deals.
• It’s cost-effective for corporates as service costs lower.
• There’s better information flow between a market maker and the customer. Thanks to one-on-one contact.

Disadvantages of OTC Markets Compared to Exchanges

• There’s increased credit risk associated with each OTC trade. The probability of the occurrence of credit risk is dependent on the life of the contract. As the life of the contract increases, the end-user may get more exposed to financial constraints that may prevent him/her from being able to honor his/her end of the bargain. The market variables that influence the price of the derivatives are also more likely to increase.
• Less transparency.

Risks in OTC Markets

g. Identify risks associated with OTC markets and explain how these risks can be mitigated.

As already discussed, over-the-counter (OTC) derivatives are privately negotiated contracts between two parties without going through an exchange or other intermediary. OTC derivative markets provide a way for companies to hedge their risk in areas such as interest rates, foreign currency exchange rates, and commodity prices.

However, OTC derivative markets also come with a dark side.

Lack of standardization

One of the key risks associated with OTC derivatives is the lack of standardization. Unlike exchange-traded derivatives, which have standardized contract terms, OTC derivatives contracts are customized to fit the needs of the two parties involved. This can make it difficult to value and assess the risks associated with these instruments.

In addition, the lack of standardization makes it difficult to create accurate models for pricing and risk management purposes. As a result, end-users may find themselves taking on more risk than they realize.

Counterparty risk
Another key risk associated with OTC derivatives is counterparty risk. This is the risk that one of the parties involved in the transaction will default on their obligations under the contract.

This risk is mitigated to some extent by collateral agreements, whereby each party agrees to post collateral (usually in the form of cash) in order to secure their obligations. However, collateral agreements only go so far in mitigating counterparty risk; if one party defaults and does not have enough collateral to cover their obligations, the other party may still incur losses.

Liquidity risk
OTC derivative markets are often less liquid than exchange-traded markets. This means that there may be fewer buyers and sellers willing to trade at any given time, which can lead to wider bid-ask spreads (the difference between the price at which a market maker is willing to buy an asset and the price at which they are willing to sell it).

Liquidity risk can also make it difficult for end-users to exit their positions when they want or need to. This can lead to forced selling at unfavorable prices, incurring losses that could have been avoided had there been more liquidity in the market.

Systemic risk

Systemic risk refers to a market-wide event that would originate from an initial park only to trigger a chain reaction that could devastate the financial markets. Such a spark could be the failure of a player considered “too big to fail.”

According to Ben Bernanke, an American economist, a too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences.

Collateralization in OTC Markets

h. Describe the role of collateralization in the OTC market and compare it to the margining system.

Collateralization is a risk-reduction technique used in the over-the-counter (OTC) markets. In OTC trading, collateral is posted by both parties to mitigate the risk of counterparty default. This security deposit protects each party from loss in the event that the other party cannot honor its obligations under the original contract.

Unlike margining in traditional exchanges, where traders post only a fraction of the total value of their trade as collateral, OTC market participants may be required to post a significant amount of collateral, sometimes as high as the full value of the trade. For example, if two banks are entering into an interest rate swap worth $10 million, each bank may have to post $5 million in collateral with an independent third party as security against default by either counterparty.

In most cases, collateral is posted in the form of cash or highly liquid securities, such as government bonds. Depending on the asset class being traded, other forms of collateral may be accepted, such as art or real estate. Collateral requirements can fluctuate depending on creditworthiness assessments made by central clearinghouses or by independent credit rating agencies. More stringent requirements are usually imposed on counterparties with lower credit ratings in order to offset the increased risk of default.

Collateral requirements are contained in the annex  – a document that sets out the specific terms of the deal. It also includes things like the type of derivative, the notional amount, the settlement date, and any other details that are specific to that particular contract.

Special Purpose Vehicles

i. Explain the use of special purpose vehicles (SPVs) in the OTC derivatives market

An SPV is a nonbank financial institution that is typically structured as a trust, company, or partnership. SPVs are usually bankruptcy remote, which means that the default of another party will not cause the SPV to default. The use of an SPV can help to mitigate counterparty and credit risk.

In the OTC derivatives market, transactions are often conducted between two counterparties without going through an exchange. This leaves counterparties exposed to each other’s credit risk. To mitigate this risk, parties can use an SPV. When using an SPV, one party transfers assets to the SPV in exchange for cash. The terms of the OTC derivative contract are then between the two counterparties and the SPV. If one counterparty defaults, the other counterparty is still able to receive payment from the assets held by the SPV.

Question 1

A trader wants to purchase 10,000 shares of YYB on margin. The current market price of YYB is $40 per share. How much should the trader part with in order to be able to purchase on margin?

1. $600,000
2. $400,000
3. $200,000
4. $0

Solution

The correct answer is C.

When buying on margin, an investor borrows part of the purchase cost from their broker. The Federal Reserve’s Regulation T allows investors to borrow up to 50% of the purchase price of securities on margin, but brokers might have stricter requirements.

Given that the trader wants to purchase 10,000 shares of YYB and the current market price is $40 per share, the total purchase cost would be:

10,000 shares × $40/share = $400,000

At the Regulation T margin requirement of 50%, the trader would need to put up:

50% of $400,000 = $200,000

Question 2

Which of the following best describes the primary use of special purpose vehicles (SPVs) in the OTC derivatives market?

A. SPVs are primarily used to facilitate trading of standardized derivatives contracts.

B. SPVs are predominantly employed to hold the underlying assets of the OTC derivatives contracts.

C. SPVs are mainly utilized for pooling different OTC derivatives and selling them as standardized securities.

D. SPVs are primarily used to isolate certain financial risks and provide off-balance sheet financing for OTC derivatives transactions.

Solution

The correct answer is D.

In the OTC derivatives market, SPVs are mainly used to isolate specific financial risks and provide off-balance sheet financing. The structure of an SPV allows firms to separate certain assets or liabilities from the main operating company, which can be particularly useful for risk management. For OTC derivatives transactions, this means that the risks associated with these transactions can be moved off the balance sheet, making them less visible to stakeholders and, in some cases, regulatory authorities. The use of SPVs for this purpose was notably observed during financial crises when some institutions utilized them to obscure the extent of their risk exposures.

A is incorrect because SPVs in the context of OTC derivatives are not primarily used to facilitate the trading of standardized derivatives contracts. OTC derivatives are, by definition, not standardized and are instead tailored to the specific needs of the counterparties.

B is incorrect because while SPVs can be used to hold assets, their primary role in the OTC derivatives market isn’t to hold the underlying assets of the OTC derivatives contracts. Their main function is related to risk management and off-balance sheet financing.

C is incorrect because SPVs are not typically used to pool different OTC derivatives and sell them as standardized securities. While SPVs can be involved in the pooling of assets, such as in the context of securitization, this is not their primary use in the context of OTC derivatives.

 

Things to Remember

• SPVs in the OTC derivatives market are primarily utilized to isolate specific financial risks and provide off-balance sheet financing.
• The structure of an SPV allows for the separation of certain assets or liabilities from the main operating company, facilitating risk management.
• By using SPVs, risks associated with OTC derivatives transactions can be moved off the balance sheet, often obscuring the extent of risk exposures to stakeholders and regulatory authorities.
• OTC derivatives are bespoke contracts tailored to specific needs, and they are not standardized like exchange-traded derivatives.