Otc Derivatives - V2

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C DERIVATIVES - OPERATIONS
1. EXECUTIVE SUMMARY
Derivatives are an important class of financial instruments that are central to todays
financial and trade markets. They offer various types of risk protection and allow
innovative investment strategies.
Around 25 years ago, the derivatives market was small and domestic. Since then it has
grown impressively around 24 percent per year in the last decade into a sizeable and
truly global market with about 457 trillion of notional amount outstanding.
No other class of financial instruments has experienced as much innovation. Product
and technology innovation together with competition have fueled the impressive
growth that has created many new jobs both at exchanges and intermediaries as well as
at related service providers. As global leaders driving the markets development,
European derivatives players today account for more than 20 percent of the European
wholesale financial services sectors revenues and contribute 0.4 percent to total
European GDP.
Given the derivatives markets global nature, users can trade around the clock and make
use of derivatives that offer exposure to almost any underlying across all markets and
asset classes. The derivatives market is predominantly a professional wholesale market
with banks, investment firms, insurance companies and corporate as its main
participants.
There are two competing segments in the derivatives market:
The off- exchange or over-the-counter (OTC) segment and the on-exchange segment.
Only around 16 percent of the notional amount outstanding is traded on exchanges.
From a customer perspective, on-exchange trading is approximately eight times less
expensive than OTC trading.
By and large, the derivatives market is safe and efficient. Risks are particularly well
controlled in the exchange segment, where central counterparties (CCPs) operate very
efficiently and mitigate the risks for all market participants. In this respect, derivatives
have to be distinguished from e.g. structured credit linked security such as
collateralized debt obligations that triggered the financial crisis in 2007.
The derivatives market has successfully developed under an effective regulatory
regime. All three prerequisites for a well-functioning market safety, efficiency and
innovation are fulfilled. While there is no need for structural changes in the
framework under which OTC players and exchanges operate today, improvements are
possible. Particularly in the OTC segment, increasing operating efficiency, market
transparency and enhancing counterparty risk mitigation would help the global
derivatives market to function even more effectively.
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2. INTRODUCTION
What is Derivatives?
Derivatives are defined as the type of security in which the price of the security
depends / is derived from the price of the underlying asset. The most common
underlying assets include stocks, bonds, commodities, currencies, interest rates and
market indexes. The common types of derivatives include Options, Futures, Forwards,
Warrants and Swaps.
Derivatives allow users to meet the demand for cost effective protection against risks
associated with movement in the prices of the underlying. In other words, users of
derivatives can hedge against fluctuations in exchange and interest rates, equity and
commodity prices, as well as credit worthiness.
Participants in derivatives markets are often classified as either hedgers or
speculators. However, hedging and speculating are not the only motivations for
trading derivatives. Some firms use derivatives to obtain better financing terms. Fund
managers sometimes use derivatives to achieve specific asset allocation of their
portfolios.
The two major types of markets in which derivatives are traded are namely:
Exchange Traded Derivatives
Over the Counter (OTC) derivatives
Exchange traded derivatives (ETD) are traded through central exchange with
publicly visible prices.
Over the Counter (OTC) derivatives are traded between two parties (bilateral
negotiation) without going through an exchange or any other intermediaries. OTC is the
term used to refer stocks that trade via dealer network and not any centralized
exchange. These are also known as unlisted stocks where the securities are traded by
broker-dealers through direct negotiations.
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With different characteristics, the two types of markets complement each other in
providing a trading platform to suit different business needs. On one hand, exchange
traded derivative markets have better price transparency as compared to OTC markets.
Also the counterparty risks are smaller in exchange-traded markets with all trades on
exchanges being settled daily with the clearing house. On the other hand, the flexibility
of OTC market means that they suit better for trades that do not have high order flow or
special requirements. In this context, OTC market performs the role of an incubator for
new financial products.
Why OTC?
1) The Company may be small and hence not qualifying the exchange listing
requirements
2) It is an instrument that is used for hedging, risk transfer, speculation and leverage
3) OTC gives exposure to different markets as an investment avenue
4) In many cases it implies less financial burden and administrative cost for the end
users (e.g. corporate)
Swaps are widely regarded as the first modern example of OTC financial derivatives.
All OTC derivatives are negotiated between a dealer and the end user or between two
dealers. Inter-dealer brokers (IDBs) also play an important role in OTC derivatives by
helping dealers (and sometimes end users) identify willing counterparties and compare
different bids and offers.
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Types of OTC Derivatives
OTC Contracts can be broadly classified on the basis of the underlying asset through
which the value is derived:
Interest rate derivatives: The underlying asset is a standard interest rate. Examples of
interest rate OTC derivatives include LIBOR, Swaps, US Treasury bills, Swaptions and
FRAs.
Commodity derivatives: The underlying are physical commodities like wheat or gold.
E.g. forwards.
Forex derivatives: The underlying is foreign exchange fluctuations.
Equity derivatives: The underlying are equity securities. E.g. Options and Futures
Fixed Income: The underlying are fixed income securities.
Credit derivatives: It transfers the credit risk from one party to another without
transferring the underlying. These can be funded or unfunded credit derivatives. e.g.:
Credit default swap (CDS), Credit linked notes (CLN).
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OTC markets have two dimensions to it, namely customer market and interdealer
market. In customer market, bilateral trading happens between the dealers and
customers. This is done through electronic messages which are called dealer-runs
providing the prices for buying and selling the derivatives. On the other hand, in the
interdealer market, dealers quote prices to one other to offset some of the risk in the
trade. This is passed on to other dealers within fractions. This clearly provides a view
point on the customer market.
Risks managed using OTC Derivatives:
Interest rate risk: Companies prefer to take loans from banks at a fixed rate of interest
in order to avoid the exposure to rising rates. This can be achieved through interest rate
swap which locks the fixed rate for a term of loan.
Currency Risk: Currency derivatives allow companies to manage risk by locking the
exchange rate, beneficial for importer or exporter companies that face the risk of
currency fluctuations.
Commodity Price Risk: Financing in terms of expansion can only be available if the
future selling price is locked. This price risk protection is provided through customized
OTC derivative. e.g. Crude Oil producer would like to increase production in tandem to
increase in the demand. The financing will be done only if the future selling price of the
crude is locked.
2.1
OBJECTIVE AND SCOPE
The Objective of the Over-the-Counter Derivatives is to know more about the

derivatives market and understand the various products and the process flow of the
same. The on-the-job training we get has got me interest in doing this project. The basic
object of this project is knowing the different types of OTC products, its lifecycle, the
corporate actions, the process flow etc. there is a wide scope for the OTC markets as
there are some limitations of the exchange traded market so people prefer investing in
the OTC market rather than the exchange traded market as OTC are customized unlike
exchange traded are standardized, so people can opt for the products as per their
requirement.
The derivatives market is not as popular in India as in the European countries but the
talks are on, on making it in India. Its not that its not at all traded in India futures,
forwards etc. are traded on the Indian exchanges like BSE & NSE.
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2.2
COMPANY BRIEF INFORMATION
SS&C was founded in 1986 by William C. Stone and went public in 1996. In 2005 the
company was acquired by entities affiliated with The Carlyle Group and was taken
private. SS&C again became a public company in 2010, and trades on
the NASDAQ under the ticker SSNC. Mr. Stone has been the company's CEO and
Chairman of the Board since inception.
Since 1995, SS&C has acquired 40 businesses with products, services and/or
technologies in existing or complementary vertical markets.
SS&C GlobeOp is a leading fund administrator providing the world's most
comprehensive array of financial technology products and services under a public,
independent, single platform. SS&C GlobeOp expertise in business process outsourcing
supports complete lifecycle capabilities, available on a stand-alone basis to hedge
funds, fund of funds, private equity funds, family wealth offices, and managed
accounts.
SS&C Technologies (commonly referred to as SS&C) is a global provider of
investment and financial software-enabled services and software focused exclusively on
the global financial services industry. SS&C answers the outsourcing needs of the
insurance, asset management, REIT industries, alternative investments, and other
financial services industries by offering tailored solutions. These include account
administration, asset valuation, compliance processing, data gathering, investment
accounting and valuation, performance measurement, reconciliation, regulatory
reporting and statement generation.
Founded in 1986 and listed on NASDAQ (NASDAQ: SSNC), SS&C has its
headquarters in Windsor, Connecticut and offices around the world.
SS&C GlobeOp, a division of SS&C Technologies is one of the worlds largest
administrators with core competencies in private equity, hedge funds, funds of funds
and managed accounts. SS&C has been providing outsourcing and fund administration
services since 1995. Key differentiators for our business are significant staff expertise
and high employee retention rates, ownership of underlying technology and impeccable
client service. Our growth is largely driven by referrals from satisfied clients.
SS&C GlobeOp is the 4th largest fund administrator (eVestment survey Q4 2012) with
US$510 billion in alternative assets under administration in North America. SS&Cs
independent fund administration services for hedge funds will assist fund managers
with the day-to-day administrative duties associated with running their hedge fund such
as:
Fund accounting
Investor relations
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Risk analytics
Net asset value of the fund
Middle office services
Management and financial reporting
A Director leads each team and remains the primary contact to ensure that all client
needs are met and exceeded. Our team approach ensures clear communication among
all SS&Cs resources and provides each client with the highest level of customized
service.
AWARDS
Winner of Best North American Hedge Fund Administrator Award
Hedgeweek Awards 2013
Winner of Best European Administrator for Managed Accounts Award
HFMWeek Awards 2013
Top Rated Provider in Single Strategy, Single Provider categories
59 Best-in-Class Awards including: Client Service, Value, Fund Accounting, Middle
Office, Investor Services, Reporting to Investors, Reporting to Fund Managers,
Compliance and Taxation, Corporate Administration, Fund Structures, Technology,
Registered Alternative Products
Global Custodian Magazine, 2013 Fund Administration Survey Ranked
#4 on Top 10 North American Fund Administrators by AUA
EVestment Administrator Survey, 4th Quarter 2012
SS&C GlobeOp nominated for 5 awards, wins Best Technology Administrator
Shortlisted: Best Reporting Services, Best Fund-of-Fund Provider over 30 bn, Best
Managed Account Services Provider, Best Administrator over 30 bn Client Service
2011 HFMWeek Hedge Fund Services Awards
PRODUCTS & SERVICES

Private Equity Services SS&C GlobeOp is the leading provider of private equity costeffective fund administration, accounting and tax services. Our clients include high
profile financial institutions, venture capital firms and private equity divisions of
Fortune 500 firms with capital commitments ranging from start-up funds to multibillion dollar funds. SS&Cs Private Equity Fund Services leverage a leading edge
technology platform and specialized private equity team to provide middle and back
office services:
Client implementation
Fund and partnership accounting
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Capital call/distribution management

Investor tracking and investor relations support
Tax support
Management and financial reporting
Waterfall accounting
Side pocket accounting
Bank Loans
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SS&C GlobeOp has the expertise and technology to manage and account for the
intricacies and challenges of accurately valuing and managing your bank debt. Today
we manage more than 1,350+ loan facilities for more than 20 fund managers and we
can promise to properly account for these instruments and accurately report on the
results of the investment activity. Web Portal With our state of the art reporting portal,
you and your investors can get the information you need faster and easier. Key features
include:
Customized intuitive desktop with market, fund and relevant data
Underlying manager portfolio, performance, risk and fund liquidity analyses
Document management
Ad-hoc reporting
Investor Relations
NAV workflow analysis Technology Capabilities
Ownership and control of the underlying technology, Advisor Ware and Total Return
Centralized portfolio and partnership accounting management Go Applications
General Ledger, Contact Management, Reporting and Investor Web Portal
POSITION IN THE INDUSTRY

SS&C GlobeOp is a leading fund administrator providing the world's most
comprehensive array of financial technology products and services under a public,
independent, single platform. SS&C GlobeOp expertise in business process outsourcing
supports complete lifecycle capabilities, available on a stand-alone basis to hedge
funds, fund of funds, private equity funds, family wealth offices, and managed
accounts.
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3. PROBLEM IDENTIFICATION
The main cause of the global financial crisis was the largely unregulated over the
counter derivatives market internationally.
The Other Problem Areas that could be identified in an OTC could be:
Lack of a clearing house or exchange, results in increased credit or default risk

associated with each OTC contract.
Precise nature of risk and scope is unknown to regulators which lead to

increased systemic risk.
Lack of transparency.
Speculative nature of the transactions causes market integrity issues.

The Problems we face on the jobs are known as breaks. Here break, means a
discrepancy in the trade. Here are a few instances in which breaks could/ do occur:
Difference in the notional amount booked by the trader and the counterparty.
The effective date, trade date, maturity date could be different in the books of
the two parties to the contract.
Next is that there are some trades which are bilateral and some are clearing
trades. Bilateral trades are where it is agreed between the parties whereas a
clearing trade gets affirmed on a platform for e.g. DTCC. There are cases where
the trade does not appear on the DTCC platform so the team has to contact the
concerned person or the client.
For the payments and receipts of fees, interest i.e. any cash flow for that matter
we are supposed to make a wire. Here wire, means the payments details of
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the client and the counterparty. There are various funds maintained by a single
client in different currencies. So while main a wire of suppose USD the SSI
used for making a wire could be that of a JPY account. So again a break may
hit.
Sometimes there is worthless termination of the trade which also leads to a
break
Sometimes the client books the trade and then deletes it
There is partial or full termination or novation of the trade in which case the
calculation changes which needs to be done accurately or else a break strikes.
Sometimes breaks also occur when the wire is not authorized, because the
payment to be released from the account the client need to approve the wire so
created.
4. LITERATURE REVIEW
The Literature review i.e. the sources or the places from where this secondary
data has been collected is as follows:
1. Statistical release OTC derivatives statistics at end-December 2014
Monetary and Economic Department April 2015
2. The official website of ISDA (International Swaps and Derivatives
Association.
3. The White Paper on THE GLOBAL DERIVATIVES MARKET by
Deutche Borse Group.
4. Report by European Central Bank on OTC DERIVATIVES AND POST
TRADING INFRASTRUCTURES
5. Derive Alert - News and information About Derivatives Regulations.
6. Reports available on EDUPRISTINE
7. Social Science Research Network
8. Journal of Securities Operations & Custody, Vol. 4, No. 2, pp. 122-133,
2011
9. Yener Coskun , Capital Markets Board of Turkey
10. Markets Media.
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Sources:
(Richard Christopher Whalen, the Subprime Crisis: Cause, Effect and
Consequences)
Despite the considerable media attention given to the collapse of the market for
complex structured assets that contain subprime mortgages, there has been too little
discussion of why this crisis occurred. The Subprime Crisis: Cause, Effect and
Consequences argues that three basic issues are at the root of the problem, the first of
which is an odious public policy partnership, spawned in Washington and comprising
hundreds of companies, associations and government agencies, to enhance the
availability of affordable housing via the use of creative financing techniques. Second,
federal regulators have actively encouraged the rapid growth of over-the-counter
(OTC) derivatives and securities by all types of financial institutions. And third, also
bearing blame for the subprime crisis is the related embrace by the Securities and
Exchange Commission (SEC) and the Financial Accounting Standards Board of fair
value accounting. After reviewing the Bush administration's proposed solutions as
flawed, this article recommends a strategy for subprime crisis resolution. Job one is to
rebuild market confidence in structured assets by going back to first principles on issues
such as market transparency, standardization of contracts, and accounting treatment. By
reducing complexity on the trade of structured assets through simple deal structures and
providing investors with the information they need to analyze collateral, for example by
requiring SEC registration and public pricing of assets, much of the current liquidity
problem is ameliorated.
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(Christian Koehler, the Relationship between the Complexity of Financial

Derivatives and Systemic Risk)
During the last decades, a growing number of financial derivatives traded both in- and
outside organized exchanges enforced the interconnectedness of participants in
financial markets. Traditionally, scholars and practitioners argued, that
derivatives allow transferring economic risks to the market participants best able to
bear them and thereby decrease systemic risk. However, this implies the ability to
properly assess the inherent risk prior to the acquisition in order to make an informed
investment decision. In contrast to the traditional argument for the systemic benefit of
risk sharing, this paper argues that the complex design of financial derivatives
characterized by multiple derivations of pooling-based derivatives increases the
potential for a systemic crisis substantially.
Measuring Counterparty Credit Risk for Trading Products under

Basel II:
Michael Pykhtin (Board of Governors of the Federal Reserve System)
Steven H. Zhu (Banc of America Merrill Lynch; Morgan Stanley)
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We described the treatment of counterparty credit risk of OTC Derivatives under Basel
II. According to this framework, minimum capital requirements for counterparty credit
risk are to be calculated according to the corporate loan rules applied to the appropriate
exposure at default (EAD) calculated at the netting set level. We present both NonInternal and Internal Model Methods (IMM) of calculating this EAD. To obtain
supervisory approval for the IMM, banks must be able to calculate expected exposure
at the netting set level for a set of future dates. We also discussed a modeling
framework that can be used for calculating exposure distribution at a set of future dates
and, in particular, for calculating expected exposure profiles. This framework can be
used for both regulatory and internal purposes. Additionally, we explained the treatment
of margin agreements under the IMM that allows one to calculate the collateralized
EPE measures: modeling collateralized exposure and the Shortcut Method. We
discussed a general approach to modeling collateralized exposure that enables one to
compute the collateral at a future date as a function of uncollateralized exposure at
another date that precedes the primary date by the margin period of risk. Finally, we
suggested a simple and fast method under this approach for modeling collateral that
avoids the simulation of exposure at the secondary dates.
Derivatives Clearing and Settlement: A Comparison of Central Counterparties
and Alternative Structures
(Robert R. Bliss, Wake Forest University - Schools
Robert S. Steigerwald, Federal Reserve Bank of Chicago)
of
Business;
Most exchange-traded and some over-the-counter (OTC) derivatives are cleared and
settled through clearinghouses that function as central counterparties (CCPs). Most
OTC derivatives are settled bilaterally. This article discusses how these alternative
mechanisms affect the functioning of derivatives markets and describes some of the
advantages and disadvantages of each
The ISDA Master Agreement - The rise and fall of a Major Financial Instrument
(Bhushan K. Jomadar, Westminster Business School; University of Westminster School of Law)
The rapid growth and complexity of the over-the-counter (OTC) derivatives market,
particularly swaps, and the perceived risks to the financial system, continue to stimulate
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debate on regulatory controls. Too often minimized in these debates are the industry's
own efforts and incentives to produce superior mechanisms for controlling risks- in
terms of both effectiveness and efficiency than those imposed through the regulations,
while product innovation is certainly a hallmark of the derivatives industry, so too has
been its ability to develop market-based solutions for addressing risk.
This dissertation examines one such successful solution - the swap master agreement that has seen significant innovations as the swaps market has grown and matured. The
use and design of master agreements has evolved in response to demands for better
documentation that reduces negotiating costs, addresses counterparty credit risk, and
help ensure contract enforceability. Indeed, the importance of sound documentation for
reducing derivatives losses has been emphasized since the 1993 report prepared by the
Group of Thirty Global Derivatives Study Group.
Derivatives and the Legal Origin of the 2008 Credit Crisis

(Lynn A. Stout, Cornell Law School - Jack G. Clarke Business Law Institute)
Experts still debate what caused the credit crisis of 2008. This Article argues that
dubious honor belongs, first and foremost, to a little-known statute called the
Commodities Futures Modernization Act of 2000 (CFMA). Put simply, the credit crisis
was not primarily due to changes in the markets; it was due to changes in the law. In
particular, the crisis was the direct and foreseeable (and in fact foreseen by the author
and others) consequence of the CFMAs sudden and wholesale removal of centuries-old
legal constraints on speculative trading in over-the-counter (OTC) derivatives. In the
wake of the crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (Dodd-Frank Act). Title VII of the Act is devoted to turning
back the regulatory clock by restoring legal limits on speculative derivatives trading
outside of a clearinghouse. However, Title VII is subject to a number of possible
exemptions that may limit its effectiveness, leading to continuing concern over whether
we will see more derivatives-fueled institutional collapses in the future.
Regulate OTC Derivatives by Deregulating Them

(Lynn A. Stout, Cornell Law School - Jack G. Clarke Business Law Institute)
(Jean Helwege, University of South Carolina)
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As a result of the current financial crisis, there have been many calls for strict new
regulation of over-the-counter financial derivatives. This paper proposes, instead, that
we return to the now-voided common law on derivatives and consider them non-legally
enforceable gambling contracts except when one of the parties can prove a bona fide
hedging purpose. Doing this would not outlaw derivatives, but would instead require
the rise of private institutions to enforce and control them, and would discourage their
use for wild speculation. The paper includes appended comments from Jean Helwege
(Penn State University), Peter Wallison (American Enterprise Institute), and Craig
Pirrong (University of Houston), as well as a response from the author
Collateral, Netting and Systemic Risk in the OTC derivatives Market

Manmohan Singh (International Monetary Fund (IMF))
To mitigate systemic risk, some regulators have advocated the greater use of centralized
counterparties (CCPs) to clear Over-The-Counter OTC derivatives trades. Regulators
should be cognizant that large banks active in the OTC derivatives market do not hold
collateral against all the positions in their trading book and the paper proves an estimate
of this under-collateralization. Whatever collateral is held by banks is allowed to be
hypothecated (or re-used) to others. Since CCPs would require all positions to have
collateral against them, off-loading a significant portion of OTC derivatives
transactions to central counterparties (CCPs) would require large increases in posted
collateral, possibly requiring large banks to raise more capital. These costs suggest that
most large banks will be reluctant to offload their positions to CCPs, and the paper
proposes an appropriate capital levy on remaining positions to encourage the transition.
Analyzing the New OTC derivatives Regulations: A Critical Overview of

Tomorrows Legal Framework
Kevin L. Meyer (Edinburgh University School of Law; St. Andrews University School of Management; HEC Lausanne, UNIL; Pontifical University Comillas of
Madrid - Department of Financial Management , ICADE)
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Having defined, on one hand, what the real dangers of derivatives are, and on the other
hand, the observed changes from their predecessors , what are the main flaws of the
new regulations, and how could they be improved? This paper analyses the risks and
potential results of the European and US solutions to the OTC derivatives problem
The Global Market for OTC derivatives: An Analysis of Dealer Holdings
Ekaterina E. Emma (Seattle University, Department of
Gerald D. Gay (Georgia State University - Department of Finance)
Finance)
We provide a descriptive examination of the trading activities of one of the most

important intermediaries in global financial markets the OTC derivatives dealer.
These dealers play a central role in the provision of derivative products and in the
intermediation of market risks faced by financial and non-financial firms alike.
Utilizing a unique database, we analyze the derivatives holdings of 264 dealers
spanning 34 countries over the period 1995-2001. We document the geographic
composition of dealers on both country and regional levels as well as analyze trends in
dealer holdings on an aggregate and individual product level. We further analyze the
extent of global merger activity among dealers and resulting consolidation effects.
Finally, we investigate at the individual dealer level the extent and evolution of their
array of product offering
6. DATA ANALYSIS
The Research Methodology the secondary information from various sites , trainings and
on the job training.
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History of Derivatives
In finance, a derivative is an agreement based on an underlying asset. Instead of
exchanging the actual asset, agreements are made to exchange cash or other assets for
the underlying asset within a specified timeframe. As the value of the underlying asset
changes, so does the value of the derivative. Following the definition, we find that our
lives are filled with derivatives. Credit cards, service agreements, and many other
everyday contracts promise a service now in exchange for cash within the billing period
- the specified period. Rather than being the boogey man of financial destruction,
derivatives are financial tools that if used properly make our lives easier. History shows
that these financial instruments were developed to solve real world issues that needed to
be solved for business.
Origins of Derivative Instruments can be traced back to Sixth Century B.C. Renowned
philosopher of Greece; Thallus is thought to be the first person that had formulated an
agreement, which is very similar to that of option derivative of today, for making profit.
Derivatives are advanced financial instruments whose values are dependent on one or
many assets, known as underlying assets. These are nothing but contracts between two
or more people.
Value of a derivative changes with price change of its underlying asset (share,
commodity, currency and many more).
Some of these instruments are:
Forward Contract
Futures
Options
History of Derivative Instruments. Derivative Instruments are used by traders either for
hedging purposes or for leveraging their profit through speculation.
Origins of Derivative Instruments are given in a chronological manner: 6th Century
B.C.
Thallus, a Greek Philosopher, instrumented an agreement by which he secured the
rights of the olive presses. He was able to secure the same at a comparatively low rate
because of the uncertainty relating to the extent of harvest. Olive harvest for that year
was very high which generated excess demand for olive presses. This gave Thallus the
opportunity to charge a very high price from the consumers and consequently book a
heavy profit.
12th Century
During the 12th century, trade flourished in Europe. The merchants had to ship their
goods from one part of the continent to another in search of profit. But this process bore
risk of shipwreck and consequent loss. In order to bypass this problem these merchants
came out with letter de faire which were nothing but customized forward contracts.
These letters acted as evidence of the deals between the customer and the merchant. In
turn, the merchant remained obliged for making delivery of the traded commodity
whenever the customer asks for it. After some time of its initiation, the merchants
started trading of these commodities among themselves.
In Japan, the feudal lords used to issue storage tickets on surplus rice, which promised
delivery of the same at a future date. These tickets in turn were also traded in the rice
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market of Dojima.
19th Century
Derivative instruments were formulated in the early part of the 19th century and were
primarily restricted to
Chicago, USA. Need for such instruments cropped up due to seasonal fluctuations in
agricultural production, which heavily depended on the vagaries of nature. Farmers and
traders started to device forward contracts on agricultural produce from this time
around in order to hedge their risk from irregularities in production.
20th Century
more and more derivative instruments were invented in this century and their popularity
increased tremendously. Some of the factors behind this popularity are:
1. Dismantling of fixed exchange rate system
2. Invention of theoretical basis of Options, namely Black-Scholes formula
Conclusion
Derivatives were utilized in the financial markets around the world from quite a long
time whose origin can be traced back to 6th century B.C. With the passage of time, the
need of these instruments increased among various sections of the society for hedging
purposes. Later, the speculative motive of the investors also surfaced and led to its
popularity.
RISK MANAGEMENT TOOLS
Year
Risk Management Model
1938
1952
1963
1966
1973
1983
1986
1988
1992
1993
1994
1997
1998
2000
Bond duration
Markowitz mean-variance framework
Sharpes single-factor beta model
Multiple-factor models
Black-Scholes option-pricing model, Greeks
RAROC, risk-adjusted return
Limits on exposure by duration bucket
Limits on Greeks
Stress testing
Value at risk (VAR)
Risk Metrics
Credit Metrics
Integration of credit and market risk
Enterprise wide risk management
What is a derivative and how do derivatives work?

As the world melted down during the 2007-2009 collapse, investors were asking all
kinds of questions about derivatives such as, "What is a derivative?" and "How do
derivatives work?"
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What Is a Derivative?
The term derivative is often defined as something - a security, a contract - that derives
its value from its relationship with another asset or stream of cash flows. There are
many types of derivatives and they can be good or bad, used for productive things or as
speculative tools. Derivatives can help stabilize the economy or bring the economic
system to its knees in a catastrophic implosion due to an inability to identify the real
risks, properly protect against them, and anticipate so-called "daisy-chain" events where
interconnected corporations, institutions, and organizations find themselves
instantaneously bankrupted as a result of a poorly written or structured derivative
position with another firm that failed; a domino effect.
A major reason this danger is built into derivatives is because of something called
counter-party risk. Most derivatives are based upon the person or institution on the
other side of the trade being able to live up to the deal that was struck. If society allows
people to use borrowed money to enter into all sorts of complex derivative
arrangements, we could find ourselves in a scenario where everybody carries these
derivative positions on their books at large values only to find that, when it's all
unraveled, there's very little money there because a single failure or two along the way
wipes everybody out with it. The problem becomes exacerbated because many
privately written derivative contracts have built-in collateral calls that require a counterparty to put up more cash or collateral at the very time they are likely to need all the
money they can get, accelerating the risk of bankruptcy. It is for this reason that
billionaire Charlie Munger, long a critic of derivatives, calls most derivative contracts
"good until reached for" as the moment you actually need to grab the money, it could
very well evaporate on you no matter what you're carrying it at on your balance sheet.
Munger and his business partner Warren Buffett famously get around this by only
allowing their holding, Berkshire Hathaway, to write derivative contracts in
which they hold the money and under no condition can they be forced to post more
collateral along the way.
What Are Some Common Types of Derivatives?
Among the most popular and common types of derivatives you might encounter in the
real world are:
Exchange Traded Stock Options - Call options and put options, which can be used
conservatively or as extraordinarily risky gambling mechanisms, are an enormous
market. Practically all major publicly traded corporations in the United States have
listed call options and put options. The specific rules governing those in the United
States are different from those governing these derivative contracts in Europe but they
are a valuable tool depending upon how you want to use them. For example, you can
get other people to pay you to buy a stock you wanted to buy, anyway. Since we
already mentioned billionaire Warren Buffett, we'll use him as an example, again. He
used this strategy several decades ago when accumulating his enormous Coca-Cola
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stake. Exchange traded options are, from a system-wide standpoint, among the most
stable because the derivative trader doesn't have to worry about so-called counterparty
risk.
While they can be extremely risky for the individual trader, from a system-wide
stability standpoint, exchange traded derivatives such as this are among the least
worrisome because the buyer and seller of each option contract enters in a
transaction with the options exchange, which becomes the counter-party. The options
exchange guarantees the performance of each contract and charges fees for each
transaction to build what amounts to a type of insurance pool to cover any failures that
might arise. If the person on the other side of the trade gets in trouble due to a wipeout
margin call, the other person won't even know about it.
Employee Stock Options - Granted as part of compensation for working for a

company, employee stock options are a type of derivative that allow the employee to
buy the stock at a specified price before a certain deadline. The hope of the employee
is that the stock increases in value substantially before the derivative expires so he or
she can exercise the option and, commonly, sell the stock on the open market at a
higher price, pocketing the difference as a bonus. More rarely, the employee may opt to
come up with all of the exercise cost out of pocket and retain his or her ownership,
accumulating a large stake in the employer.
Futures Contracts - While futures contracts exist on all sorts of things, including stock
market indices such as the S&P 500 or The Dow Jones Industrial Average, futures are
predominately used in the commodities markets. Imagine you own a farm. You grow a
lot of corn. You need to be able to estimate your total cost structure, profit, and risk.
You can go to the futures market and sell a contract to deliver your corn, on a certain
date and a pre-agreed upon price. The other party can buy that futures contract and, in
many cases, require you to physically deliver the corn. For example, Kellogg's or
General Mills, two of the world's largest cereal makers, might buy corn futures to
guarantee they have sufficient upcoming raw corn to manufacturer cereal while
simultaneously budgeting their expense levels so they can forecast earnings for
management to make plans.
Airlines often use futures to hedge their jet fuel costs. Mining companies can sell
futures to provide greater cash flow stability by knowing ahead of time what they will
get for their gold, silver, and copper. Ranchers can sell futures for their cattle. All of
these derivative contracts keep the real economy going when prudently used as they
permit the transfer of risk between willing parties to lead to greater efficiency and better
desired outcomes relative to what a person or institution is willing and able to expose to
a chance of loss or volatility.
Swaps - Companies, banks, financial institutions, and other organizations routinely
enter into derivative contracts known as interest rate swaps or currency swaps. These
are meant to reduce risk. They can effectively turn fixed-rate debt into floating rate
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debt or vice versa. They can reduce the chance of a major currency move making it
much harder to pay off a debt in another country's currency. The effect of swaps can be
considerable on the balance sheet and income results in any given period as they serve
to offset and stabilize cash flows, assets, and liabilities (assuming they are properly
structured).
A General Rule in Life for Individual Investors: Avoid Speculative Derivatives, Both
Directly In Your Own Portfolio and on the Balance Sheets of the Companies in Which
You Invest
While individuals and families who have a substantial net worth might intelligently
deploy certain derivative strategies when working with a highly qualified registered
investment advisor - e.g., it might be possible to lower taxes and hedge against market
fluctuations when slowly disposing of a concentrated stock position acquire over a long
life or service for a specific company or to generate additional income by writing
covered call options or selling fully secured cash puts (you can learn more about that
topic here, too), both of which are far beyond the scope of what we are discussing here
- a good rule in life is to avoid derivatives at all cost in so far as you are talking about
your stock portfolio. I cannot tell you how many people I've observed go bankrupt or
wipe decades of savings off their books after buying call options in an attempt to get
rich quickly.
The same goes for investing in complex financial institutions or firms. If you can't
understand the derivative exposures of a business, do not invest in its stock and do
not buy its bonds.
Many associate the financial market mostly with the equity market. The financial
market is, of course, far broader, encompassing bonds, foreign exchange, real estate,
commodities, and numerous other asset classes and financial instruments. A segment of
the market has fast become its most important one: derivatives. The derivatives market
has seen the highest growth of all financial market segments in recent years. It has
become a central contributor to the stability of the financial system and an important
factor in the functioning of the real economy
Despite the importance of the derivatives market, few outsiders have a comprehensive
perspective on its size, structure, role and segments and on how it works.
The derivatives market has recently attracted more attention against the backdrop of the
financial crisis, fraud cases and the near failure of some market participants. Although
the financial crisis has primarily been caused by structured credit-linked securities that
are not derivatives, policy makers and regulators have started to think about
strengthening regulation to increase transparency and safety both for derivatives and
other financial instruments.
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In broad terms, there are two groups of derivative contracts, which are distinguished by
the way they are traded in the market: Over-the-counter (OTC) derivatives are contracts
that are traded (and privately negotiated) directly between two parties, without going
through an exchange or other intermediary and Exchange Traded Derivatives (ETD)
which are derivative instruments traded on the exchanges.
A security traded in some context other than on a formal exchange such as the NYSE,
TSX, AMEX, etc. The phrase "over-the-counter" can be used to refer to stocks that
trade via a dealer network as opposed to on a centralized exchange. It also refers to debt
securities and other financial instruments such as derivatives, which are traded through
a dealer network
Over-the-counter (OTC) derivatives are contracts that are traded (and privately
negotiated) directly between two parties, without going through an exchange or other
intermediary. Products such as swaps, forward rate agreements, exotic options and
other exotic derivatives are almost always traded in this way. The OTC derivative
market is the largest market for derivatives, and had been largely unregulated with
respect to disclosure of information between the parties, since the OTC market is made
up of banks and other highly sophisticated parties, such as hedge funds. Recently with
the new regulations the OTC market place is more transparent than it has been ever.
Exchange-traded derivatives (ETD) are those derivatives instruments that are traded
via specialized derivatives exchanges or other exchanges. A derivatives exchange is a
market where an individual trades standardized contracts that have been defined by the
exchange.
Some common variants of OTC products are
Swaps
Options
Forwards
EXCHANGE-TRADED VERSUS OVER-THE-COUNTER (OTC)
DERIVATIVES
An exchange traded product is a standardized financial instrument that is traded on an
organized exchange.
An over the counter (OTC) product or derivative product is a financial instrument
traded off an exchange, the price of which is directly dependent upon the value of one
or more underlying securities, equity indices, debt instruments, commodities or any
agreed upon pricing index or arrangement.
The most common types of derivative products are interest rate swaps, caps and their
offshoots. Over 90% of commercial bank derivative trading is interest rate related due
to the natural ebb and flow of their corporate finance and hedging activity.
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The reason derivative products exist is that users often need customized products as the
standardization of exchange products can lead to hedging mismatches and gap
exposures.
The main differences between exchange and OTC products can be viewed as follows:
Exchange Traded
OTC Traded
Pricing
Standardized
Customized
Maturity
Standardized
Customized
Quantity
Standardized
Customized
Frequency
Standardized
Customized
Quality
Standardized
Customized
Documentation
Standardized
Customized
Regulatory Body
One entity
Various
The primary difference is standardization versus customization. This leads to a crucial

distinction. When dealing in exchange traded products terms are standardized and the
clearinghouse guarantees that the other side of any transaction performs to its
obligations. That is, it assumes all contingent default risk so both sides do not need to
know about each others credit quality. This differs from customized OTC products
where there is no clearinghouse to guarantee performance.
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The need to know the counterpartys credit standing is an essential distinction. The
exposure difference is quite significant. In summary:
Exchange Traded = Standardizes = Market Risk
OTC Traded = Customized = Market Risk + Counterparty Risk
Regulatory Oversight
All companies are subject to certain rules and regulations imposed by state and federal
authorities. When a stock is listed in an exchange, however, the regulatory oversight
increases dramatically. For example, the firm must make certain key financial
information available to the public free of charge, and employees of the firm are
prohibited from trading the firm's stock if they are in possession of material non-public
information that could impact the stock's performance. Shares of companies that fail to
follow these and other requirements can be removed from the exchange in a process
called "delisting". The share price, as well as the value of the entire firm, must also
exceed certain thresholds. It is therefore difficult for a small firm's stock to trade in an
exchange. However, any stock can be traded over the counter.
Counterparty Risk
When you buy or sell something OTC in a private transaction, there is always the risk
of not getting what you bargained for. The other party might not be able to deliver the
stock, bond or other security within the agreed upon time frame. It might also deliver a
different kind of stock or bond than promised. These risks are broadly referred to as
counterparty risk. In an exchange, however, counterpart risk is not an issue. The trading
occurs through brokers who are closely monitored by both the exchange and the
Securities and Exchange Commission. Investors buy exchange traded securities with
greater confidence and therefore pay more for such stocks. Because of this, businesses
are better off selling shares through an exchange rather than in a private transaction.
Standardization
Stocks usually have only a few varieties, such as common, preferred, Type A and Type
B shares. But other financial securities can come in numerous flavors. For example, a
stock option -- which gives the holder the right but not the obligation to buy or sell a
stock, bond or other investment -- comes with an expiration date. Options also have
"strike" prices, which is the price the option holder can buy or sell a security if she so
chooses. While exchange traded options have only a few expiration dates for any given
month, and the strike prices go up in specific increments, an OTC option can have any
expiration date and strike price the buyer and seller agree upon
Intermediation
In the OTC market, you can do business directly with the buyer or seller. If a small
firm's retiring owner wants to sell his shares, for example, you can buy these shares
directly from him. While it is advisable to bring a lawyer to document the transaction,
the transaction requires no intermediary. However, transactions in an exchange must go
through a broker dealer. No matter how much money you have, you cannot access the
buyers and seller in the New York Stock Exchange or NASDAQ on your own. You
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must pay commissions to a broker, who will then execute the transaction on your
behalf.
Variants of OTC Derivatives Contracts
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OTC TRADE LIFE CYCLE
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OTC Trade Processing Flow

Each OTC trade goes through various stages until its maturity. While it goes through its
various life cycle events namely, Terminations, Assignments, etc. there are specialists
who ensure these trades are well kept and maintained in the companys books of
records. They also ensure that all agreed obligations of the trade agreement are also
honored.
Trade Capture They maintain and are the gate keepers to the correct and complete
trade flow to the trade order management system and ultimately to the accounting
engine.
Trade Confirmations Prime responsibility of having the trade agreements signed by
both the parties, after they are verified and confirmed to be depicted by the trade
booked in the systems. These trade agreements are governed by an authority
International Swaps and Derivatives Association.
Reconciliation Trade and Cash
Trade Reconciliation engulfs the portfolio reconciliation which reconciles every trade
detail with that of the counterparty and ensures that ultimately each position with its
every detail, ties out with that of the Counterparty.
Cash Reconciliation ensures all cash arising out of these trades are settled with the
external counterparts in time accurately. They shoulder the responsibility of all cash
events including Corporate Actions, Resets, and Swap Cash flows, Premium and Payoff
calculation and settlement with the counterparts.
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Collateral Management They closely monitor the exposure of the trade portfolio
daily and mitigate risk by cashing the exposure in their favor on a daily basis. They
shoulder the responsibility to ensure that at any given point in time, the risk of the
portfolio is mitigated, by calling back all cash posted as Margin/collateral security,
when the trading portfolio is in their favor. Likewise they would also pay the price of
being exposed to the counterparty when the exposure is in counterpartys favor.
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Basic derivatives trading lifecycle

Its worth noting that the derivatives trading lifecycle is considerably longer and more
complicated than the lifecycle associated with simple equity trades. Indeed, trading
derivatives requires creating and maintaining complex legal contracts that may evolve
over months or years.
Stage
1. Pre-trade
2. Trade
Activity
Definition
Bilateral
documentation Overall
parameters
of
and internal approvals
trading
activities
are
established
through
a
bilateral master agreement.
Counterparty credit reviews
are conducted to establish
credit lines and trading
limits.
Trade execution
Parties agree on terms via
phone, fax, and/or electronic
means.
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3. Post-trade
Trade capture
Trade
affirmation
matching
Confirmation
Settlement
Trade details are captured

for processing and risk
management. This may be
manual (via trade tickets) or
electronic.
or Trade details may be
provided by one party
and affirmed by the other, or
each party may exchange
records for matching.
Final confirmation of the
trade details are secured and
exchanged. Confirmations
may be paper/electronicbased.
Cash or other assets are
exchanged per the terms of
the contract.
Firms serving as custodians of the contract need to maintain information about terms
and conditions, as well as ensure that these are properly settled. Such information must
also be recorded and shared among appropriate parties.
CORPORATE ACTIONS.
Corporate actions are the actions initiated at the corporate level having material impact
on the companys financial structure and ultimately the stakeholders who are the
owners of company. In other words corporate actions are events initiated by issuer of
securities that directly or indirectly affects its shareholders or bondholders, whether
positively or negatively. It is important that the investor has a clear picture of what a
corporate action indicates about a companys financial affairs and how that action will
influence the companys share price and performance. This knowledge, in turn, helps
investors in determining whether to buy or sell the stock in question. These actions are
decided upon by the board of directors with intent of increasing the profitability of the
company or for the benefit of the stakeholders.
Types of Corporate Actions
Corporate actions are classified as mandatory, voluntary and mandatory with choice
corporate actions.
Mandatory Corporate Action: A mandatory corporate action is an event initiated by
the corporation by the board of directors that affects all shareholders. Participation of
shareholders is mandatory for these corporate actions. Mandatory Corporate Actions
Includes Cash Dividend, Stock Splits, Mergers, Pre-refunding, Return of capital, Bonus
Issue, Asset ID Change, Pari-Passu and Spinoffs.
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Stock Split and Reverse Spilt: A corporate action in which a companys

existing shares are divided into multiple shares. For Ex. A company with 100 shares
of stock price Rs 50 per share (100*50 = 5000). The company splits it shares 2 for 1.
There are now 200 shocks for Rs 25 each (200*25 = 5000). The reason why
companies split their stock is to make them more affordable to investors because
stock price reduces after it is split. Likewise, reverse split increases the stock price
while reducing number of outstanding shares.
Spin-Offs: Spin off means a company breaking up itself into smaller units. The
creation of an independent company through the sale or distribution of new shares of
an existing business/division of a parent company.
Dividend Payouts: Dividend is the payment made to the investor for sharing
the profits a company has made.
Mergers and Acquisitions: Mergers is an event where two or more companies

merge into one aiming to be more competitive and for more profitability. Likewise
Acquisition means a bigger company acquiring a smaller one for further expansion.
Bonus Issue: It is an additional dividend given to the shareholders that can be

in cash or in the form of stock. When companies have outstanding performance with
surplus profit, they may decide to issue bonus to the shareholders.
Voluntary Corporate Action:

Voluntary corporate actions are actions requiring a decision from the investor on
whether or not to participate. Corporation will not process these actions automatically
because the decision on whether to participate will vary for every investor.
Shareholders may choose to take no action which will leave their securities unaffected
by the Corporate Action. Voluntary corporate action includes Tender Offer, Rights
issue, making buyback offers to the shareholders while delisting the company from the
stock exchange etc.
Buyback: Buyback is an action in which company offers to buys back its stock
from the current shareholders at an attractive price. The reason is to reduce the
shares outstanding in the market or to reduce the stake of shareholders in company.
Rights Issue: It refers to offering additional shares to the current shareholders

of the stock. This is done by companies to raise capital for further expansion which
provide its existing shareholders the right to buy the stock at discounted rates than
price making it more lucrative.
Mandatory with Choice Corporate Action: This corporate action is a mandatory

corporate action for the shareholder but they are being presented with options. An
example is cash or stock dividend option with one of the options as default.
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Shareholders may or may not submit their elections. In case a shareholder does not
submit the election, the default option will be applied.
Dividend Payouts: Dividend is the payment made to the investor for sharing
the profits a company has made. It can be cash dividend or stock dividend where
company offers stock as a dividend to the current shareholders.
Fundamentals and Market Characteristics

Before discussing the prerequisites for a well-functioning derivatives market, it is
useful to consider some fundamentals and characteristics of the market. First the basics
of derivatives are explained, and then the size, growth and function of the derivatives
market and the role of European players are discussed. This is followed by an
explanation of the derivatives trading value chain, Then review of competitive
dynamics in the derivatives market.
Derivatives have not only widened the investment universe, they have also significantly
lowered the cost of investing. The total transaction cost of buying a derivatives contract
on a major European stock index is around 60 percent lower than that of buying the
portfolio of underlying shares. If one compares the cost of gaining exposure to less
liquid assets such as real estate, the cost differential between the derivative and the
direct investment in the underlying is even significantly higher.
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Derivatives also allow investors to take positions against the market if they expect the
underlying asset to fall in value. Typically, investors would enter into a derivatives
contract to sell an asset (such as a single stock) that they believe is overvalued, at a
specified future point in time. This investment is successful provided the asset falls in
value. Such strategies are extremely important for an efficiently functioning price
discovery in financial markets as they reduce the risk of assets becoming excessively
under- or overvalued
Types of derivatives
Derivatives can be traded OTC or on exchanges. OTC derivatives are created by an
agreement between two individual counterparties. OTC derivatives cover a range from
highly standardized (so-called exchange look-alike) to tailor-made contracts with
individualized terms regarding underlying, contract size, maturity and other features.
Most of these contracts are held to maturity by the original counterparties, but some are
altered during their life or offset before termination.
Exchange-traded derivatives, on the other hand, are fully standardized and their
contract terms are designed by derivatives exchanges. Most derivatives products are
initially developed as OTC derivatives. Once a product matures, exchanges
industrialize it, creating a liquid market for a standardized and refined form of the
new derivatives product. The OTC and exchange-traded derivatives then coexist side by
side.
The number of OTC-traded derivatives is unlimited in principle as they are customized
and new contracts are created continuously. A broad universe of exchange-traded
derivatives exists as well: for example, over 1,700 different derivatives are listed on the
three major global derivatives exchanges (Chicago Mercantile Exchange, Eurex and
Euronext. Liffe).
Derivatives can be differentiated along three main dimensions
Type of derivative and market place: Derivatives can be traded bilaterally OTC
(mostly individually customized contracts) or multilaterally on exchanges
(standardized contracts).
Type of underlying: Underlying does can be financial instruments themselves,
physical assets, or any risk factors that can be measured. Common examples are
fixed-income, foreign exchange, credit risk, equities and equity indices or
commodities. Exotic underlyings, for example, weather, freight rates, or
economic indicators.
Type of product: The three main types are forwards (or futures), options and
swaps.10) they differ in terms of their dependence on the price of the
underlying.
Functions in derivatives trading
The derivatives value chain can be broken down into derivatives pre-trading,
derivatives trading and clearing (including the rare exercise of derivatives), and
(also rare) payment and delivery (Exhibit 6). These functions are organized
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differently for OTC and exchange-traded derivatives. Broker-dealers (large

investment or universal banks), exchanges and clearing houses are the main
service providers along the value chain.
Pre-trading comprises the origination and channeling of derivatives orders to
marketplaces for the execution of transactions.
Trading consists of the matching of buyers and sellers in derivatives contracts.
Execution means that the buyer and the seller respectively enter into the
derivatives contract.33) Often dedicated derivatives dealers constantly provide
price offers for contracts. This is called market making and is also a part of
trading.
A derivatives trade creates an open derivatives contract. Derivatives clearing
manages these open contracts until their termination, and is closely linked to
derivatives trading as open contracts can be traded again and need to be
managed throughout the contracts potentially very long maturities.
An essential element of derivatives clearing is therefore position management,
which deals with keeping track of open derivatives contracts. This usually also
includes managing the risks present during the life of a contract. Part of
derivatives clearing is also the termination of a derivatives contract, which can
be triggered by four actions or events: (1) cancelling out the original contract
with an offsetting contract, (2) giving up the contract to another trading party,
(3) expiry, or (4) exercise the only event that requires settlement.
Two alternatives exist for settlement: either exchanging the net value of the
contract when exercised via a cash payment or the physical delivery of the
underlying against the payment of the agreed price.
Most derivatives contracts are not settled physically or do not even foresee
physical settlement, as is the case for interest rate, credit default swaps and most
exotic derivatives. Only about 2 percent of all transactions (in terms of notional
amount) are physically settled at Eurex
The organization of derivatives trading and clearing differs between the OTC
and exchange segments, described in detail in the following paragraphs.
On-exchange derivatives trading value chain

Derivatives broker-dealers originate and collect orders from their customers. These are
then forwarded to derivatives exchanges for execution. The exchanges are central
marketplaces where all orders are collected and matched. Trading parties usually
remain anonymous. Matched orders add new open contracts, alter the counterparties of
existing open contracts or offset existing open contracts. Clearing houses that step in
between the two trading parties as a CCP provide clearing for all trades and position
management of all open contracts. The clearing house nets all offset open derivatives
contracts of each trading party across all other trading parties (multilateral netting) and
serves as a CCP to each trading party guaranteeing the fulfillment of each contract. The
box above explains the measures that CCPs use to achieve a very high degree of safety.
As the clearing house keeps track of all trading parties open contracts it also receives
exercise requests and serves as a middleman to the other counterparty of a contract
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being exercised. It usually also generates the settlement instructions for the payments
resulting from derivatives contracts and, if necessary, the required physical transfer of
the underlying asset.
OTC derivatives trading value chain

In the case of OTC derivatives, broker-dealers forward originated orders to their own
derivatives desks and through them if required to other derivatives dealers. Trading
then takes place by two trading parties bilaterally agreeing a new contract. These
contracts can be tailored completely to the specific needs of the two contractual parties;
or they are identical to standardized exchange-traded contracts (so-called lookalikes). Secondary trading usually does not take place in OTC contracts given their
high degree of customization. Instead, offsetting contracts are entered into to cancel
existing contracts economically. Electronic and multilateral OTC marketplaces have
been established to help find a suitable transaction partner for common OTC contracts,
such as interest rate swaps or foreign exchange transactions, where some degree of
standardized contract parameters already exist (often referred to as plain vanilla
contracts.
Each trading party/derivatives dealer is responsible for the clearing and position
keeping itself and must keep track of its open contracts and risk position. Netting and
collateralization are measures to mitigate counterparty risk also for OTC derivatives. In
the OTC segment netting and collateralization happens mostly on a bilateral-only basis.
Only for some sufficiently standardized OTC products, clearing houses offer CCP
clearing services with multilateral netting as well. Swap Clear is an example of OTC
clearing services for interest rate swaps. While bilateral netting agreements are in place
for virtually all OTC trades, collateralization was used for approximately 59 percent of
OTC transactions in 2007. CCP services are currently used only for an estimated 16
percent of all interest rate swap transactions
Settlement of derivatives transactions works similarly for the exchange and OTC
segments. Payments resulting from derivatives transactions are concluded between the
trading parties (in the case of exchange traded derivatives also the CCP). Payments are
carried out via central bank accounts, which are used only by some CCPs, or via
commercial bank accounts. In the rare case of physical settlement, custodian banks,
ICSDs or CSDs provide the transfer of ownership of securities
RISK MITIGATION IN THE DERIVATIVES MARKET
To fulfill its role of protecting against risks and providing the means for investing, the
derivatives market itself must be safe and mitigate unwanted risks effectively
The derivatives market has arrangements in place to mitigate unwanted risks that arise
from conducting derivatives transactions. From a practical point of view these
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arrangements have proven successful the unwanted risks in the derivatives market
have been reduced to a tolerable level. Even when failures of market participants have
occurred, they have not seriously affected other market participants
The OTC and exchange segments have taken different approaches to mitigate unwanted
risks.
Counterparty risk
The scale of aggregated credit risks varies significantly between the OTC and exchange
segments. If no counterparty risk mitigation mechanisms were in place in both
segments, the required regulatory capital for counterparty risk would be around 400
billion in the OTC segment and 90 billion in the exchange segment. This is not
surprising given the large differences between the two markets in the notional amount
outstanding.
The most common means of mitigating counterparty risk are netting and
collateralization of counterparty risk exposures. In the OTC segment, these lead to the
theoretic regulatory capital required being reduced by around 70 percent to
approximately 120 billion. For example, 76 percent of the counterparty risk exposure
arising from OTC transactions is subject to bilateral netting agreements and the total
amount of collateral posted in relation to OTC derivatives transactions is around 1,200
billion.
Central counterparties, as detailed in section 2.3, provide multilateral netting across all
trading parties and are well protected against default as they use several lines of defense
against their counterparty risk exposure. As a consequence, the use of CCPs reduces the
trading parties regulatory capital for credit risk from derivatives transactions to zero
irrespective of whether the transaction is OTC or on exchange.
Taking into account all lines of defense, CCP clearing is safer than bilateral clearing in
terms of counterparty risk. No major clearing house has ever come close to being in
financial difficulty, while there have been cases of individual derivatives dealers that
defaulted.
Operational risk
The key to minimizing operational risk is to minimize manual handling and
interference in derivatives trading and clearing processes, and to design reliable
electronic processes.
Both the OTC and exchange segments use automated processing. The exchange
segment is fully automated across trading and clearing. Derivatives exchanges and
clearing houses usually have fully automated interfaces resulting in seamlessly
integrated processes.
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The OTC segment uses automated processing solutions primarily for standard products.
Newly introduced, exotic, less liquid or complex OTC derivatives are usually handled
manually, with resulting delays and risks of errors. By December 2007, only 20 percent
of OTC equity derivatives were processed electronically compared to about 44 percent
of OTC interest rate derivatives and 91 percent of credit derivatives.
Operational risk events do occur more often in the OTC segment but they have not
resulted in the complete failure of players with the exception of outright fraud.
Legal risk
Legal risk is principally addressed by using standardized derivatives contracts and
agreements. It is particularly important that netting agreements work in case of default,
that is, that they are not impaired by insolvency procedures and other creditors claims
The OTC segment achieves this through the use of standard master agreements,
which are developed under the leadership of its industry associations, such as the ISDA.
The master agreements are supported by legal opinions from leading law firms in all
relevant jurisdictions. This self-regulatory solution provides sufficient legal certainty
to a large part of the OTC derivatives segment. As a result, legal disputes concerning
derivatives contracts arise in the OTC segment only occasionally.
Derivatives exchanges offer almost only standardized derivatives contracts. They alone
in close coordination with the clearing houses that serve as CCPs for the exchange
design these contracts assisted by respective legal support. All contracts are subject to
one chosen and known jurisdiction. Together with legally binding rules for participating
in the trading and clearing of derivatives, this ensures that legal uncertainty for onexchange derivatives is negligible.
Liquidity risk
Most exchange-traded derivatives and standard OTC derivatives, such as foreign
exchange forwards and interest rate swaps, are very liquid. Market participants can
expect to find a party to trade with at a fair price. Liquidity risk is higher in smaller or
exotic OTC derivatives sub-segments or new, not yet established exchange-traded
derivatives segments.
Illiquidity is almost not a problem in the exchange segment and rarely a problem in the
OTC segment. However, in situations where the entire financial market is under stress,
such as since the start of the financial crisis in 2007, bilateral trading in the OTC
segment can be difficult as there are fewer potential trading parties available for
transactions. This can be aggravated by the lack of credible price information, as details
of OTC transactions are not disclosed to other trading parties and the public. Finally,
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trading parties might be dependent on a particular OTC derivatives dealer to unwind

positions if necessary. As a consequence, illiquidity tends to be a bigger problem in the
OTC than the on-exchange segment, which has proven highly liquid even throughout
the recent financial crisis.
Over-the-Counter Options for Customized Solutions
The only problem with listed exchange-traded options is that a suitable derivative for an
investment strategy youve developed may not exist in standardized form. For the wellheeled investor, this presents no problem because he or she can work with an
investment bank through their wealth manager to structure custom over-the-counter
options tailored to their exact needs.
How Over-the-Counter Options Differ from Regular Stock Options

In essence, these are private party contracts written to the specifications of each side of
the deal. There are no disclosure requirements and you are limited only in your
imagination as to what the terms of the over-the-counter options are. In an extreme
example, you and I could structure an over-the-counter option that required me to
deliver a set number of Troy ounces of pure 24 karat gold based upon the number of
whales spotted off the coast of Japan over the next 36 months. Frankly, that would be a
very stupid transaction, but you get the idea.
The appeal of over-the-counter options is that you can transact in private and negotiate
terms. If you can find someone who doesnt think your over-the-counter option
proposal presents much risk to their side, you can get an absolute steal.
Counterparty Risk in Over-the-Counter Options
The problem with over-the-counter options is that they lack the protection of an
exchange or clearinghouse. You are effectively relying on the promise of the
counterparty to live up to their end of the deal. If they cant perform, you are left with a
worthless promise.
This is especially dangerous if you were using the over-the-counter options to hedge
your exposure to some risky asset or security. (When this happens, its known as basis
risk your hedges fall apart and youre left exposed. That is why the world financial
institutions panicked when Lehman Brothers failed as a huge investment bank, they
were party to countless over-the-counter options that would have entered a black hole
of bankruptcy court.)
This is what is referred to in financial regulatory circles as a daisy-chain risk. It only
takes a few over-the-counter derivative transactions before it becomes virtually
impossible to determine the total exposure an institution would have to a given event or
asset. The problem becomes even more complex when you realize that you may be in a
position where your firm could be wiped out because one of your counterpartys had
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their counterparty default on them, making them insolvent. This is why famed
investor Warren Buffett had referred to unchecked derivatives as financial weapons of
mass destruction.
A Primer about Clearing and Settlements
As we have seen in the last couple of years, the global financial markets are a web of
interconnected institutions and processes. Market participants depend on each other for
stability as well as profits. However, while focus has traditionally been paid to the
reward side of the equation, the proper functioning of this network relies on a clear
understanding of risk management.
This primer highlights the critical role played by the clearinghouse, the risks that a
central counterparty (CCP) bears, and the tools applied to mitigate those risks.
The Role of the Clearinghouse

The matching of buyers with sellers is only the beginning of a successful transaction. In
the absence of instantaneous transfer of goods with payment, there exists a need for
financial intermediaries to manage inherent "counterparty risk," or the potential for
either side to not fulfill their contractual obligations.
This risk is particularly acute for derivatives instruments where settlement is much
further out than the T+3 period for cash equities.
Clearinghouses are institutions that manage this risk and guarantee contractual
performance by playing the role of central counterparty. This is achieved through the
application of two key concepts - novation and collateral.
Novation is the replacement of a contract between the original

counterparties with two new contracts; one between the buyer's clearing
broker and the CCP, and another between the CCP and the seller's clearing
broker. By stepping into the trade, the CCP effectively becomes the only
legal entity that the market participants need to be concerned with. As
novation occurs at a large scale, trades are netted; thereby reducing the
number of open positions and increasing capital efficiency.
The CCP's ability to guarantee performance hinges upon the second concept
of collateral. Through the duration of the contract, performance bonds are
posted by the buyer/seller in order to remove all market risk on a daily basis
and revalue the contract to current market prices, i.e. "marking-to-market."
In addition to unrealized losses, margin for potential losses may be called
for. Settlement banks are institutions that facilitate the transfer of this
collateral from the clearing brokers to the CCP, and represent an important
link in the system. In the same way, any settlement margin that is due to the
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clearing members from the CCP is an exposure that must be managed

carefully, as it is contingent upon the settlement system working properly.
Risks and Mitigate
Without sufficient funds flowing in each direction as expected, the orderly
functioning of our interconnected financial systems would be at jeopardy.
Therefore, while it can be tempting to take post-trade operations for granted,
it is necessary for each market participant to be aware of clearinghouse and
settlement system risk, and monitor them in a controlled manner.
Credit risk
As discussed earlier, the CCP takes on credit risk on behalf of the original
counterparties. The CCP mitigates this risk through the use of multilateral
netting and marking-to-market positions through the day with an appropriate
amount of performance bond collateral. Should a clearing member default,
and the collateral margined is insufficient to cover the obligations, loss
medialization may be implemented - where funds are sourced from a
guarantee fund with contributions from the remaining members of the CCP.
Liquidity risk
Fulfilling payment obligations in a timely manner is particularly critical for
clearinghouses, as to not bring solvency into question. Whether it is a
payment of option premium pass-through, profits on outstanding contracts,
reimbursements of cash initial margins, or payments for deliveries,
clearinghouses must balance liquidity with cost of funds. Upon exhausting
the collateral posted by the defaulting clearing member, the clearinghouse
may tap into a line of credit in order to settle the account. For instance, CME
Clearing has a facility in place that can provide $800 million in funds within
an hour.
Principal risk
While the majority of transactions are of the cash settlement variety, there
are some that require physical delivery, with Delivery versus Payment
(DVP). As a result, clearinghouses risk the payment if goods are not
delivered, and risk the goods if payment is not received.
Settlement bank risk
In the case of settlement bank defaults occurring after funds are debited
from a clearing member's account and credited to a clearinghouse's account,
but before being transferred to another settlement bank, the clearinghouse
would be liable. Legal agreements can reduce this risk by calling for netting
of payments to clearing members from the clearinghouse, or having the loss
shared by the settlement banks that were scheduled to receive the funds.
Legal risk
Having proper bankruptcy procedures in place is paramount in the event of
default by either clearing member or settlement bank. Multilateral netting is
an operation that is of particular concern given its role in reducing open
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positions, and preventing payouts to a defaulting party even as funds are not
available for collection by a clearinghouse.
Operational risk
The risks arising from technology breakdowns or human error compound
the aforementioned risks. For instance, inaccurate variation margin
calculations would increase credit risk, whereas not having the proper
human procedures in place would allow for deficient monitoring of liquidity
or documentation controls. Redundant and separated data centers with
periodic business resiliency drills can maintain a clearinghouse's crisis-ready
condition.
OTC derivatives statistics at end-December 2014

.OTC derivatives markets contracted in the second half of 2014. The notional amount
of outstanding contracts fell by 9% between end-June 2014 and end-December 2014,
from $692 trillion to $630 trillion. Exchange rate movements exaggerated the
contraction of positions denominated in currencies other than the US dollar. Yet, even
after adjusting for exchange rate movements, notional amounts were still down by
about 3%.
The gross market value of outstanding derivatives contracts which provide a more
meaningful measure of amounts at risk than notional amounts rose sharply in the
second half of 2014. Market values increased from $17 trillion to $21 trillion between
end-June 2014 and end-December 2014, to their highest level since 2012. The increase
was likely driven by pronounced moves in long-term interest rates and exchange rates
during the period.
Central clearing, a key element in global regulators agenda for reforming OTC
derivatives markets to reduce systemic risks, made further inroads. In credit default
swap markets, the share of outstanding contracts cleared through central counterparties
rose from 27% to 29% in the second half of 2014. In interest rate derivatives markets
too, central clearing is becoming increasingly important. More detail on these
highlights is provided
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Recent developments in OTC derivatives markets

The overall size of the over-the-counter derivatives market continued to contract in the
second half of 2014. The notional amount of outstanding OTC derivatives contracts,
which determines contractual payments and is one indicator of activity, fell by 9%
between end-June 2014 and end-December 2014, from $692 trillion to $630 trillion
(Table 1 and Graph 1, left-hand panel). Over this period, exchange rate movements
exaggerated the contraction of positions denominated in currencies other than the US
dollar.1 yet, even after adjusting for this effect; notional amounts at end-December
2014 were still about 3% lower than at end-June 2014. The gross market value of
outstanding derivatives contracts that is, the cost of replacing all outstanding contracts
at market prices prevailing on the reporting date sharply increased in the second half
of 2014. This contrasts with the downward trend of recent years. Market values stood at
$21 trillion at end-December 2014, their highest level since 2012 and up from $17
trillion at end-June 2014 (Graph 1, center panel)
The gross market value represents the maximum loss that market participants would
incur if all counterparties failed to meet their contractual payments and the contracts
were replaced at current market prices.2 Market participants can reduce their exposure
to counterparty credit risk through netting agreements and collateral. Accordingly, gross
credit exposures adjust gross market values for legally enforceable bilateral netting
agreements, although they do not take account of collateral. Gross credit exposures
equaled $3.4 trillion at end-December 2014, up from $2.8 trillion at end-June 2014
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(Table 1). This represented 16.1% of gross market values at end-December 2014, which
was about the same share as reported at end-June 2014 and in line with the average
since 2008 (Graph 1, right-hand panel). Interest rate derivatives the interest rate
segment accounts for the majority of OTC derivatives activity. For single-currency
interest rate derivatives at end-December 2014, the notional amount of outstanding
contracts totaled $505 trillion, which represented 80% of the global OTC derivatives
market (Table 3). At $381 trillion, swaps account for by far the largest share of
outstanding interest rate derivatives. Notional amounts fell sharply in the second half of
2014, driven by a contraction in euro denominated interest rate contracts (Graph 2, lefthand panel). The notional value of euro contracts declined from $222 trillion to $167
trillion between end-June 2014 and end-December 2014 (or equivalently from 162
trillion to 138 trillion). Trade compression to eliminate redundant contracts
contributed to the decline.
The volume of compressions picked up noticeably in 2014, especially of interest rate
swaps cleared through central counterparties (CCPs).3 Another factor that likely
contributed to the decline was reduced hedging activity in response to revised
expectations regarding the outlook for monetary policy in the euro area.4 The notional
value of interest rate contracts in other currencies increased in the second half of 2014.
US dollar contracts increased from $161 trillion to $173 trillion between end-June 2014
and end December 2014. Yen, pound sterling and Canadian dollar contracts also
increased, after adjusting for the impact of exchange rate movements on the reported
US dollar positions of interest rate derivatives denominated in these currencies. The
gross market value of interest rate derivatives increased in the second half of 2014,
from $13 trillion to $16 trillion. Declines in long-term yields to, in many instances, new
lows contributed to the increase in market values by widening the gap between market
interest rates on the reporting date and rates prevailing at contract inception. Increases
in market values were reported for interest rate derivatives denominated in all of the
major currencies and were especially marked in pound sterling and Canadian dollar
contracts (Table 3).
The gross market value of euro-denominated contracts rose from $7.4 trillion at endJune 2014 to $8.2 trillion at end-December 2014 (or equivalently from 5.4 trillion to
6.7 trillion). The overall decline in notional amounts was not accompanied by a
significant change in the maturity distribution of interest rate derivatives. As a share of
all maturities outstanding, contracts with maturities of over five years rose from 22% to
24% between end-June 2014 and end-December 2014 The distribution of interest rate
derivatives by counterparty points to a continued shift in activity towards financial
institutions other than dealers, including CCPs. Central clearing is a key element in
global regulators agenda for reforming OTC derivatives markets to reduce systemic
risks. The notional amount of interest rate contracts between derivatives dealers has
been falling more or less steadily since 2008, to $70 trillion at end-December 2014
compared with a peak of $189 trillion at end-June 2008 (Graph 2, right-hand panel).
Contracts between dealers and other financial institutions, including CCPs, stood at
$421 trillion at end-December 2014, down from $463 trillion at end-June 2014.
Notwithstanding this absolute decline in notional amounts, the relative importance of
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other financial institutions continued to increase in the second half of 2014; their share
of all outstanding contracts rose to 83% at end-December 2014 from 82% at end-June
2014 and 49% at end-June 2008. The shift towards central clearing exaggerates the
growth in notional amounts for other financial institutions because, when contracts are
cleared through CCPs, one trade becomes two outstanding contracts.5 Turning to the
concentration of derivatives activity among reporting dealers, as of end December 2014
in many segments the concentration of dealers positions had fallen to levels close to or
below those reported prior to 2008 (Table 9a). Herfindahl indices for the US dollar
interest rate swap (IRS) market had fallen back to 2007 levels, and for yen and euro
markets to below 2007 levels. However, in the sterling and Swiss franc IRS markets,
concentration remained well above 2007 levels.
Foreign exchange derivatives Foreign exchange derivatives make up the second largest
segment of the global OTC derivatives market. At end-December 2014, the notional
amount of outstanding foreign exchange contracts totaled $76 trillion, which
represented 12% of OTC derivatives activity (Table 2). Contracts against the US dollar
represented 89% of the notional amount outstanding at end-December 2014. The gross
market value of foreign exchange derivatives increased to its highest level for several
years. It increased to $2.9 trillion at end-December 2014 from $1.7 trillion at end-June
2014 and $2.4 trillion at end-June 2013. The marked appreciation of the US dollar
against most other currencies contributed significantly to this increase. For example, at
end-December 2014 the US dollar rose to its highest level in nine years against the
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euro, and in seven years against the yen. In the second half of 2014 the increase in the
market value of contracts against the yen was especially pronounced, rising from $0.4
trillion to $0.8 trillion (or equivalently from 36 trillion to 95 trillion). The latest data
show little change in the instrument composition of foreign exchange derivatives.
Forwards and foreign exchange swaps jointly accounted for close to half of the notional
amount outstanding (Table 1). However, currency swaps which typically have a
longer maturity than other foreign exchange derivatives and thus are more sensitive to
changes in market prices accounted for the largest proportion of the gross market
value. In contrast to the interest rate derivatives market, in the foreign exchange
derivatives market inter-dealer contracts continued to account for nearly as much
activity as contracts with other financial institutions. The notional amount of
outstanding foreign exchange contracts between reporting dealers totaled $32 trillion at
end-December 2014, and contracts with financial counterparties other than dealers $34
trillion (Table 2). The inter-dealer share has averaged around 43% since 2011, up from
less than 40% prior to 2011. Among instruments, inter-dealer activity accounts for a
greater share of more complex contracts, such as currency swaps (53% of notional
amounts) and options (46%). Credit default swaps while in 2007 credit derivatives had
come close to surpassing foreign exchange derivatives as the second largest segment in
the global OTC derivatives market, notional amounts have since declined more or less
steadily. They fell to $16 trillion at end-December 2014 from $19 trillion at end-June
2014 and a peak of $58 trillion at end-2007 (Graph 3, left-hand panel).
The market value of CDS also continued to decline, to $593 billion at end-December
2014 in gross terms and $136 billion in net terms (Graph 3, right-hand panel). The net
measure takes account of bilateral netting agreements covering CDS contracts but,
unlike gross credit exposures, is not adjusted for cross-product netting. Recent declines
in overall CDS activity reflected mainly a contraction in inter-dealer activity. The
notional amount for contracts between reporting dealers fell from $9.5 trillion at endJune 2014 to $7.7 trillion at end-December 2014 (Table 4). Notional amounts with
banks and securities firms also decreased in the second half of 2014, from $2 trillion to
$1.3 trillion. In line with the overall trend, notional amounts cleared through CCPs
declined in absolute terms between end-June 2014 and end-December 2014, from $5.2
trillion to $4.8 trillion (Table 4). That said, as a proportion of all CDS activity, central
clearing continued to make inroads. The share of outstanding contracts cleared through
CCPs rose from less than 10% in 2010 (when data for CCPs were first reported
separately) to 26% at end-2013 and 29% end-December 2014 (Graph 3, center panel).
The share of CCPs is highest for multi-name products, at 37%, and much lower for
single-name products, at 23% (Table 4). Contracts on CDS indices in the multi-name
segment are more amenable to central clearing, as they tend to be more standardized
than those in the single-name segment. While the shift towards central clearing had
earlier contributed to an increase in netting, the latest data indicate that the trend
towards netting may have stalled. Netting enables market participants to reduce their
counterparty exposure by offsetting contracts with negative market values against
contracts with positive market values. As a result of the increased use of legally
enforceable bilateral netting agreements, net market values as a percentage of gross
market values had fallen to 21% at end-2013 from 26% at end-2011 (Graph 3, right47
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hand panel). However, they rose to 23% at end-December 2014. The prevalence of
netting is greatest for CDS contracts with other dealers and CCPs, where it reduced net
market values as a percentage of gross values to 17% and 16%, respectively, at endDecember 2014 (Table 4). Netting is least prevalent for contracts with insurance
companies (84%) and non-financial customers (69%).
The distribution of underlying reference entities indicates that contracts referencing
nonfinancial firms have declined at a somewhat faster pace than those referencing other
sectors. Outstanding CDS contracts referencing non-financial firms stood at $6 trillion
at end-December 2014, representing 34% of all CDS (Table 7). This is down from 40%
at end-2011 (when this breakdown was first reported). Contracts referencing financial
firms and multiple sectors both stood at $4 trillion at end-December 2014, followed by
those referencing sovereigns at $2 trillion. By rating, contracts referencing investment
grade entities equaled $10 trillion and those referencing lower-rated or unrated entities
$7 trillion (Table 5).
The distribution of outstanding CDS by location of the counterparty showed little
change at end-December 2014. The CDS market is very international; CDS with
counterparties from the same country in which the dealer is headquartered accounted
for only 21% of outstanding contracts at end June 2014, or $3 trillion (Table 8). Most of
the foreign counterparties were from Europe, followed by the United States.
Equity-linked and commodity derivatives the notional amount of OTC derivatives

linked to equities totaled $8 trillion at end-December 2014 and the gross market
value $0.6 trillion (Table 1). Activity in equity-linked contracts declined
precipitously during the 200709 global financial crises, from a peak of $10 trillion
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at end-June 2008 to an average of $6 trillion between 2009 and 2012. Notional

values have since rebounded, but market values have fluctuated around the same
level for the past few years.
For OTC derivatives linked to commodity contracts, the latest data show no sign of
a rebound from the sharp correction that occurred after the 200709 crises. Dealers
expanded their commodity derivatives business rapidly between 2004 and 2007 but
subsequently scaled back their outstanding positions. From a peak of $8 trillion at
end-2007, the notional amount of outstanding OTC commodity derivatives
contracts declined to $3 trillion at end-2009 and less than $2 trillion at end-2014.
The gross market value of OTC commodity contracts stood at $0.3 trillion at endDecember 2014.
Instrument types Forward contracts: Forward contracts represent agreements
for the delayed delivery of financial instruments or commodities in which the buyer
agrees to purchase and the seller agrees to deliver, at a specified future date, a
specified instrument or commodity at a specified price or yield. Forward contracts
are generally not traded on organized exchanges and their contractual terms are not
standardized. The reporting exercise also includes transactions where only the
difference between the contracted forward outright rate and the prevailing spot rate
is settled at maturity, such as non-deliverable forwards (i.e. forwards which do not
require physical delivery of a non-convertible currency) and other contracts for
differences.
Swaps: Swaps are transactions in which two parties agree to exchange payment
streams based on a specified notional amount for a specified period. Forwardstarting swap contracts are reported as swaps.
Options: Option contracts confer either the right or the obligation, depending upon
whether the reporting institution is the purchaser or the writer, respectively, to buy
or sell a financial instrument or commodity at a specified price up to a specified
future date.
Single-name CDS: A credit derivative where the reference entity is a single name.
Multi-name CDS: A contract where the reference entity is more than one name, as
in portfolio or basket CDS or CDS indices. A basket CDS is a CDS where the credit
event is the default of some combination of the credits in a specified basket of
credits.
Index products: Multi-name CDS contracts with constituent reference credits and
a fixed coupon that are determined by an administrator such as MarkIt (which
administers the CDX indices and the iTraxx indices). Index products include
tranches of CDS indices
Definitions for foreign exchange transactions outright forward: Transaction
involving the exchange of two currencies at a rate agreed on the date of the contract
for value or delivery (cash settlement) at some time in the future (more than two
business days later). This category also includes forward foreign exchange
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agreement (FXA) transactions, non-deliverable forwards and other forward

contracts for differences.
Foreign exchange swap: Transaction involving the actual exchange of two
currencies (principal amount only) on a specific date at a rate agreed at the time of
the conclusion of the contract (the short leg), and a reverse exchange of the same
two currencies at a date further in the future at a rate (generally different from the
rate applied to the short leg) agreed at the time of the contract (the long leg). Both
spot/forward and forward/forward swaps should be included. Short-term swaps
carried out as tomorrow/next day transactions should also be included in this
category.
Currency swap: Contract that commits two counterparties to exchange streams of
interest payments in different currencies for an agreed period of time and to
exchange principal amounts in different currencies at a pre-agreed exchange rate at
maturity.
Currency option: Option contract that gives the right to buy or sell a currency with
another currency at a specified exchange rate during a specified period. This
category also includes exotic foreign exchange options such as average rate options
and barrier options.
Definitions for single-currency interest rate derivatives:

Forward rate agreement (FRA): Interest rate forward contract in which the rate to
be paid or received on a specific obligation for a set period of time, beginning at
some time in the future, is determined at contract initiation.
Interest rate swap: Agreement to exchange periodic payments related to interest
rates on a single currency; can be fixed for floating, or floating for floating based
on different indices. This group includes those swaps whose notional principal is
amortized according to a fixed schedule independent of interest rates. Interest rate
option: Option contract that gives the right to pay or receive a specific interest rate
on a predetermined principal for a set period of time.
Table 1 Global OTC derivatives market

Table 2 Global OTC interest rate derivatives market
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7. RESULTS AND LEARNINGS

It is and has been a very great experience working with SS&C GlobeOp. I have
learnt many new things and got a lot to learn. It is a mixture of classroom training, & on
the job training, acquiring product knowledge, getting knowledge and real time
experience of how the various products are been traded and what is are the various
process flow. Overall the work environment is very friendly with a blend of knowledge
and many different aspects. Also helps to improve our other skills as well.
8. LIMITATIONS AND FUTURE SCOPE

Derivatives are the financial instruments which gives appreciable returns with the
transfer of risk and hedging. But many of the investors have lack of knowledge in
derivative instruments hence the research study reveals the significance of derivative
products, how they can hedge with these products and guides in choosing the best
derivative instrument
FACTORS LIMITING EFFECTIVENESS
(TRANSPARENCY) POLICY
OF
THE
DISCLOSURE
Systemic risk arising from the interconnectedness of banks and other financial
institutions through the derivatives markets is one of the important concerns in the
global financial crisis."^'^ It is shown in the banking literature that better disclosure
(transparency) and hence market discipline framework have both advantages and
disadvantages in terms of firm/system-wide risk management, protection of consumers
and systemic risk management. The author considers that discussions on benefits and
factors limiting effectiveness of disclosure in banking sector also provides valuable
knowledge for potential problems with transparency policy in OTC markets and
derivatives transactions. Therefore, below, there is a comparative analysis of the
negative impacts of more transparency in banking and in OTC markets and derivatives
trading.
Regulators and supervisors support official discipline and market discipline (through
disclosure-based phonies) to improve the effectiveness of risk management practices
and hence self-discipline in financial firms, particularly in banking. Das and Quintyn
suggest that instilling and using sound governance practices are a shared responsibility
of market participants and regulatory agencies."'' So, both regulators and market
participants support better official discipline and a market discipline framework to
improve financial firms' governance."
Allen and Herring' ' argue that the trends toward globalization, conglomeration,
consolidation and more extensive involvement in OTC derivatives imply that problems
like DBLG, BCCI, Barings Bank and LTCM are likely to be even more complex in the
future. From the perspective of the global financial crisis, it may be argued that the
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authors were correct to underline the importance of the potential problems of OTC
markets and derivatives
During the global financial crisis, one of the most significant problems associated with
the OTC market was the lack of transparency. Due to this lack of transparency,
improper reporting and inappropriate valuation measures, the market continued to
deteriorate .The regulators, supervisors and even the market actors themselves were not
aware of the actual level of risk and this caused panic to expand rapidly.
Effectiveness of disclosure (and hence transparency) may lessen for several reasons.
First of all, structural problems may limit the positive impacts of disclosure, such as
lack of a proper regulatory disclosure framework or less efficient market practices on
disclosure.'*'' Secondly the negative reactions of market players or unsophisticated third
parties may reduce the effectiveness of more transparency. Thirdly, although the
derivatives disclosures are informative to investors, their usefulness is hinted by the
extent to which the information is aggregated.
FUTURE SCOPE - POST TRADE PROCESSING
A world of new acronyms: CCPs, SDRs, SEFs and more...
The OTC Derivatives market continues to evolve rapidly. However the nature of this
change is somewhat different from the growth in volumes and broadening of product
types that typified the years leading up to the crisis of 2008. Since then we have seen a
marked shift towards addressing post trade processing inefficiencies and operational
risk.
The regulators are fiercely and determinedly pushing the industry to lower counterparty
risk and increase transparency. This is changing the landscape radically for OTC
derivatives, with new central counterparties, clearing services, trading venues and
reporting repositories. The Dodd-Frank Act and the EU directive on Markets
Infrastructure mean no participant in this industry will be immune from these changes.
The impact of Basel III and other regional initiatives introducing more onerous capital
requirements will soon be felt.
Some current examples of challenges we help would be:
Clearing - Bi-directional connections to multiple CCPs for client or house

clearing - out-of-the-box
Affirmation - Implement STP to eliminate dual keying of trades into affirmation

services and core systems.
Trade Reporting - Real time and on-going regulatory reporting under a variety
of G20 jurisdictions.
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Reconciliation - Clearing House populations and Trade Repository populations

with your internal books and records
Collateral - Increasing requirements for electronic messaging in the collateral

space
9. CONCLUSION AND RECOMMENDATIONS

Clearinghouses play a critical role in the financial markets. Central counterparties like
DTCC are instrumental in minimizing the fallout from defaulting institutions, as was
evident in the wake of Lehman Brothers' collapse. As proliferation of investment
products expands at a quicker pace, the need for clearing of both exchange-traded and
OTC transactions grows in direct proportion.
However, just as clearinghouses reduce risk, increase capital efficiency, and enhance
price transparency through painstaking controls, they too must be carefully monitored
and regulated for the safety of its clearing participants and stakeholders.
Even as the SEC and CFTC provide industry oversight, it is incumbent upon each
clearing member to conduct strict reviews of their central counterparties and ensure the
highest standards of risk management and financial safeguards.
(1) Derivatives including exchange-traded futures and options, as well as OTC
contracts that are negotiated bilaterally, i.e. interest rate swaps and credit
default swaps.
(2) An ancillary benefit of clearinghouses is that of enhanced price discovery with
anonymity for market participants.
(3) The National Securities Clearing Corporation (NSCC) nets down the total
number of trading obligations requiring financial settlement by 98% across all
US broker-to-broker trades involving equities, corporate and municipal debt,
American depositary receipts, exchange-traded funds and unit investment
trusts.
(4) The actual amount of "settlement variation" or "variation margin" required can
be on a gross basis or net of all open long and short positions. Assets considered
eligible for performance bond requirements include cash, U.S. treasuries, and
equities.
(5) While the two sides of a futures contract offset each other perfectly, options
contacts have an asymmetric quality - buyers do not have a continuing margin
requirement beyond the initial option premium, whereas sellers are liable for
additional funds when the option they write increase in value.
The potential loss is typically estimated as the historical price fluctuation at a
95-99% confidence interval.
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(6) For example, as of February 2011, CME Clearing's settlement bank

relationships include: JP Morgan Chase, Harris Trust & Savings, Bank of New
York, Lakeside Bank, Burling Bank, Bank of America, Brown Brothers
Harriman and Fifth Third Bank.
(7) Clearinghouses such as the Clearing Corporation maintain perfect records -zero client losses resulting from a clearing participant default -- achieving this
by collecting initial margin at least once daily, continually monitoring net markto-market obligations and significant open positions, and calling variation
margin at least 2x daily.
(8) DTCC assisted in winding down $500 billion of Lehman's open trading
positions across equities, MBS, and US government securities. The European
Central Counterparty (Euro CCP), DTCC's overseas subsidiary, closed out and
settled 21 million in pending trades by Lehman Brothers International.
The derivatives market is very dynamic and has quickly developed into the most
important segment of the financial market. Competing for business, both derivatives
exchanges and OTC providers, which by far account for the largest part of the market,
have fueled growth by constant product and technology innovation. The competitive
landscape has been especially dynamic in Europe, which has seen numerous market
entries in the last decades. In the process, strong European players have emerged that
today account for around 44 percent of the global market in terms of notional amount
outstanding.
The derivatives market functions very well and is constantly improving. It effectively
fulfills its economic functions of price efficiency and risk allocation. The imperatives
for a well-functioning market are clearly fulfilled:
The exchange segment, in particular, has put in place very effective risk
mitigation mechanisms mostly through the use of automation and CCPs.
For its users, the derivatives market is highly efficient. Transaction costs for
exchange-traded derivatives are particularly low.
Innovation has been the markets strongest growth driver and has been
supported by a beneficial regulatory framework especially in Europe.
Overall, it is clearly desirable to preserve the environment that has contributed to the
impressive development of the derivatives market and the success of European players
in it. There is thus no need for any structural changes in the framework under which
OTC players and exchanges operate today. However, some aspects of the OTC segment
in particular can still be improved further. Safety and transparency, and operational
efficiency could be enhanced along proven and successful models helping the global
derivatives market to become even safer and more efficient.
56
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10. REFERENCES
Amato, J D and Jacob Gyntelberg (2005): CDS index tranches and the pricing
of credit risk correlations, BIS Quarterly Review, March 2005, pp 7387.
Ansi, A and O Ben Ouda (2009): How option markets affect price discover on
the spot markets: A survey of the empirical literature and synthesis,
International Journal of Business and Management, vol 4, no 8, pp 15569.
Banque de France (2010): Financial Stability Review, July 2010.
Berkshire Hathaway Inc. (2002): 2002 Annual Report,
http://www.berkshirehathaway.com/2002ar/2002ar.pdf
Carlson, J B, B Craig, P Higgins and W R Melick (2006): FOMC
communications and the predictability of near-term policy decision, Federal
Reserve Bank of Cleveland Economic Commentary, June 2006.
Duffie, D and K Singleton (2003): Credit risk, Princeton University Press,
Princeton, US.
ISDA (2008): The ISDA market survey: What the results show and what they
dont show? ISDA Research Notes, no 1, autumn 2008.
Jarrow, R and S Turnbull (1999): Derivatives securities, South-Western College
Publishing.
Nystedt, J (2004): Derivative market competition: OTC markets versus
organized derivative exchanges, IMF working paper WP/04/61.
Swan, E (2000): Building the global market: A 4000 year history of derivatives.
Kluwer Law International, London, UK.
Whaley R (2008): Understanding VIX, Vanderbilt University, Owen Graduate
School of Management, memo.
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Types of OTC Derivatives

OBJECTIVE AND SCOPE

The Objective of the Over-the-Counter Derivatives is to know more about the

COMPANY BRIEF INFORMATION

PRODUCTS & SERVICES

Capital call/distribution management

POSITION IN THE INDUSTRY

Lack of a clearing house or exchange, results in increased credit or default risk

Precise nature of risk and scope is unknown to regulators which lead to

Speculative nature of the transactions causes market integrity issues.

(Christian Koehler, the Relationship between the Complexity of Financial

Measuring Counterparty Credit Risk for Trading Products under

Derivatives and the Legal Origin of the 2008 Credit Crisis

Regulate OTC Derivatives by Deregulating Them

Collateral, Netting and Systemic Risk in the OTC derivatives Market

Analyzing the New OTC derivatives Regulations: A Critical Overview of

We provide a descriptive examination of the trading activities of one of the most

Risk Management Model

What is a derivative and how do derivatives work?

Employee Stock Options - Granted as part of compensation for working for a

The primary difference is standardization versus customization. This leads to a crucial

Variants of OTC Derivatives Contracts

OTC TRADE LIFE CYCLE

OTC Trade Processing Flow

Basic derivatives trading lifecycle

Trade details are captured

Stock Split and Reverse Spilt: A corporate action in which a companys

Mergers and Acquisitions: Mergers is an event where two or more companies

Bonus Issue: It is an additional dividend given to the shareholders that can be

Voluntary Corporate Action:

Rights Issue: It refers to offering additional shares to the current shareholders

Mandatory with Choice Corporate Action: This corporate action is a mandatory

Fundamentals and Market Characteristics

Functions in derivatives trading

differently for OTC and exchange-traded derivatives. Broker-dealers (large

On-exchange derivatives trading value chain

OTC derivatives trading value chain

trading parties might be dependent on a particular OTC derivatives dealer to unwind

How Over-the-Counter Options Differ from Regular Stock Options

The Role of the Clearinghouse

Novation is the replacement of a contract between the original

clearing members from the CCP is an exposure that must be managed

OTC derivatives statistics at end-December 2014

Recent developments in OTC derivatives markets

Equity-linked and commodity derivatives the notional amount of OTC derivatives

at end-June 2008 to an average of $6 trillion between 2009 and 2012. Notional

agreement (FXA) transactions, non-deliverable forwards and other forward

Definitions for single-currency interest rate derivatives:

Table 1 Global OTC derivatives market

7. RESULTS AND LEARNINGS

8. LIMITATIONS AND FUTURE SCOPE

Clearing - Bi-directional connections to multiple CCPs for client or house

Affirmation - Implement STP to eliminate dual keying of trades into affirmation

Reconciliation - Clearing House populations and Trade Repository populations

Collateral - Increasing requirements for electronic messaging in the collateral

9. CONCLUSION AND RECOMMENDATIONS

(6) For example, as of February 2011, CME Clearing's settlement bank

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