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Exchanges and OTC Markets

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.

How Exchanges Alleviate Counterparty Risk

An exchange is a central financial location where traders can trade (exchange) standardized financial instruments such as futures contracts.

A major risk when trading derivatives is counterparty risk, the other party’s risk failing to honor their end of the contract. For example, if company A enters an interest rate swap to give fixed-rate payments in exchange for floating rate payments from company B pegged on the six-month LIBOR, A and B are said to be counterparties. If large moves in the floating rate occur, B could default, resulting in a financial loss for A.

Organized exchanges use several mechanisms to alleviate counterparty risk. These include:

Margins

These are assets that are transferred from one trader to another. They act as protection against the risk of defaulting of the other party. Consider two traders, trader X (seller) and Y (buyer), trading with a margin agreement in place. In case the price of the traded commodity goes below the agreed-upon price, the buyer (Y) can request a refund from the seller (X) for an amount equal to the difference between the agreed-upon price and the price of the commodity as of now.

This will reduce the chances of the buyer defaulting in a bid to buy the commodity at the current price (which is cheaper than the agreed-upon price). If the current prices are more than the agreed-upon price, trader Y (buyer) will be required to provide margin to trader X (seller).

Netting

“Netting” describes the procedure of combining long and short positions and calculating the CCP’s net exposure to a member. Assume, for example, 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).

Central Counterparties

Central counterparties are used in exchanges to clear transactions between members. 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.

Benefits of Trading Using CCPs

  1. Promotes trust between traders who will not even need to know the creditworthiness of each other.
  2. CCPs help members to easily close out positions.

Ways in Which CCPs Handle Credit Risk

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

Netting

Netting involves long and short positions offsetting each other.

Variation Margin and Settlements

Future contracts are traded on a daily basis up-to-the the maturity period. A member who is trading with the CCP will have to pay the CCP in case the price of the traded commodity decreases. The payment made should correspond to the price decline of the commodity. Similarly, if the price of the commodity increases, the CCP will have to pay the member an amount that corresponds to the price increase.

Daily settlements have simplified the closing out of future contracts by making the contract’s maturity date less useful. There are no interests associated with variation margin payments as they are settled on a daily basis and not on the maturity date.

Example

Suppose that trader A enters 4 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.

Initial Margin

In addition to the variation margin, a trader is required to deposit an initial margin with the CCP. Initial margins save CCPs from losses in case a trader is unable to pay the variation margin.

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

Default fund contributions take care of the remaining amount not covered by the initial margin. The equity of a CCP is at risk only after exhausting the default fund contributions of all members.

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 on Margin

This occurs when a trader borrows funds from a broker and uses the funds to buy assets. To be able to borrow funds, the trader must deposit a margin of 50% of the value of the assets. The remaining amount will then be provided by the broker, who will keep the assets as security. The difference between the value of the shares and the amount loaned to the trader by the broker forms the balance in the margin account.

The minimum margin balance as a percentage of the value of the shares is known as the maintenance margin. A margin balance should not drop below the maintenance margin. If it drops below the maintenance margin, the trader will be required to provide additional margin, failure to which the broker will sell the shares.

Over-the-Counter Trading vs. Exchange Trading

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 specialized 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.

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 Associated with OTC Markets

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.

Counterparty Risk

As we’ve seen before, counterparty risk is the risk that a counterparty in a derivatives contract will, either willingly or unintentionally, default on contractual obligations.

Some of the measures taken to mitigate these risks in OTC markets include:

Bilateral Netting

This refers to the offsetting of positions between counterparties due to the fungibility of the contracts. Suppose, for instance, that Bank X bought $50 million worth of euros from Y. At the same time, it sold an otherwise identical contract to Bank A in the amount of $40 million. If the two trades had gone through the same clearinghouse, the net exposure of Bank X would only be $10 million.

Collateral

Collaterals are similar to margins in the exchange-traded markets. They are posted so as to hedge against credit risk. To calculate the collateral and the type of security to be posted, the net value of outstanding derivatives is used. This is specified in the Credit Support Annex (CSA).

Special Purpose Vehicles

SPVs are subsidiary companies created by the main company to handle a project without putting the parent company at risk. If the parent company encounters any financial complication, the SPV continues its operations as normal and vice versa.

Derivative Product Companies

A derivative product company, DPC, is generally an AAA-rated entity set up by one or more banks to serve as a bankruptcy-remote subsidiary of a major dealer. DPCs trade on behalf of the dealer. In case of any financial trouble, the dealer will be required to offset the losses, failure to which the DPC will be sold to another entity, or the transactions may be closed out at mid-market prices.

DPCs differs from SPVs in that it’s separately capitalized to obtain an AAA-rating. The DPC shields external counterparties from the knock-on effects that may play out when the DPC parent fails.

DCPs offer flexibility and decentralization while still allowing counterparties to enjoy benefits associated with exchange-based trading.

Credit Default Swaps

CDSs have been designed to reflect an insurance contract. The buyer pays a regular premium to the seller, who then pays the seller in case of the occurrence of a specified event. Companies called Monolines have been set up to specifically offer credit protection using default swaps. Some insurance companies equally offer credit protection alongside their insurance contracts.

Question

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

The correct answer is C.

A trader needs an initial margin of 50% of the value of the assets to be purchased.

Option A is incorrect. To short a stock, a margin of 150% at the time of the trade is required, but only in the case of shorting a stock.

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