Competition In The Global Derivatives Market

M. Isi Eromosele

The derivatives market is highly competitive. Generally, there are two indications for competition in a market: new market entries and customer choice. The derivatives market scores high on both. New players regularly enter the market and customers can choose between many substitute products across both its segments.

Market entries

The derivatives market can be characterized as highly dynamic with plenty of market entries. There are no legal, regulatory or structural barriers to entering the derivatives market. Almost all derivatives exchanges across the world have been created during the last three decades only.

The United States was home to the first wave of equity options exchange foundations in the 1970s in the wake of academic breakthroughs in options valuation and the introduction of computer systems. The CBOE was founded in 1973, the American Stock Exchange, Montreal Exchange and Philadelphia Stock Exchange started options trading in 1975 while the Pacific Exchange commenced options trading in 1976.

A second wave of new derivatives exchanges occurred in the 1980s and early 1990s in Europe. During that time, a financial derivatives exchange was established in almost every major Western European financial market - the most important ones being London with Liffe in 1982, Paris with Matif in 1986, and Frankfurt with DTB in 1990. Most of these organizations formed their own clearing houses.

In recent years, new derivatives exchanges have started to compete with existing derivatives marketplaces. In such a dynamic market, the already large number of derivatives exchanges is likely to continue growing.

Away from the developed markets, related activities in emerging markets were also intensive. Three derivatives operations have commenced trading in the Middle East since 2005: Dubai Gold and Commodities Exchange, Kuwait Stock Exchange, and IMEX Qatar.

India saw four new derivatives exchanges set up between 2000 and 2003: National Stock Exchange of India, Bombay Stock Exchange, MCX India, and NCDEX India. China has seen the establishment of two derivatives exchanges since 2005: Shanghai Futures Exchange and China Financial Futures Exchange.

Banks are also constantly entering new product segments: Goldman Sachs, for example, has invested heavily into the commodity derivatives segment in recent years. BNP Paribas has successfully developed the OTC equity derivatives segment. There are numerous successful market entries into the OTC segment such as ICAP or GFI, which provide trading services via electronic platforms, or of clearing service providers such as Liffe’s Bclear.

Varied Choices

This dynamic market offers users choice falling into three categories: (a) choice between different OTC dealers within the OTC segment, (b) choice between the OTC and on-exchange segments for many contract types, and (c) choice between different derivatives exchanges.

To deliver maximum benefits to its users and to the economy, the derivatives market must meet three prerequisites: derivatives trading and clearing must be safe, the market must be innovative and it must be efficient.

There are wanted and unwanted risks in the derivatives market. Both the OTC and exchange segments have arrangements in place to mitigate unwanted risks, although these are inherently more effective in the exchange segment.

The main reason for using derivatives is to gain exposure to a wanted risk. This usually is a market risk that either could compensate for an opposite risk (hedging) or that an investor wants to benefit from for investment purposes - via the positive evolution of market prices.

However, as with other financial instruments, there are also unwanted risks associated with derivatives trading that investors seek to avoid. These unwanted risks are counterparty, operational, legal and liquidity risks.

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 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.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group

The Global Derivatives Market - An Analysis

By M. Isi Eromosele

Derivatives are an important class of financial instruments that are central to today’s financial and trade markets. They offer various types of risk protection and allow innovative investment strategies.

The derivatives market is predominantly a professional wholesale market with banks, investment firms, insurance companies and corporations as its main participants.

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 structured credit linked security such as collateralized debt obligations that triggered the financial crisis in 2008.

Derivatives are totally different from securities. They are financial instruments that are mainly used to protect against and manage risks, and very often also serve arbitrage or investment purposes, providing various advantages compared to securities. Derivatives come in many varieties and can be differentiated by how they are traded, the underlying they refer to, and the product type.

A derivative is a contract between a buyer and a seller entered into today regarding a transaction to be fulfilled at a future point in time, for example, the transfer of a certain amount of US dollars at a specified USD-EUR exchange rate at a future date.

Over the life of the contract, the value of the derivative fluctuates with the price of the so-called “underlying” of the contract - in this case, the USD-EUR exchange rate. The life of a derivative contract, that is, the time between entering into the contract and

the ultimate fulfillment or termination of the contract, can be very long – in some cases more than ten years.

Given the possible price fluctuations of the underlying and thus of the derivative contract itself, risk management is of particular importance.

Derivatives must be distinguished from securities, where transactions are fulfilled within a few days. Some securities have derivative-like characteristics - such as certificates, warrants, or structured credit-linked securities; but they are not derivatives.

Derivatives make future risks tradable, which gives rise to two main uses for them. The first is to eliminate uncertainty by exchanging market risks, commonly known as hedging. Corporations and financial institutions, for example, use derivatives to protect themselves against changes in raw material prices, exchange rates, interest rates etc.

They serve as insurance against unwanted price movements and reduce the volatility of companies’ cash flows, which in turn results in more reliable forecasting, lower capital requirements and higher capital productivity. These benefits have led to the widespread use of derivatives: 92 percent of the world’s 500 largest companies manage their price risks using derivatives.

The second use of derivatives is as an investment. Derivatives are an alternative to investing directly in assets without buying and holding the asset itself. They also allow investments into underlyings and risks that cannot be purchased directly.

Examples include credit derivatives that provide compensation payments if a creditor defaults on its bonds, or weather derivatives offering compensation if temperatures at a specified location exceed or fall below a predefined reference temperature.

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.

The derivatives market has grown rapidly in recent years as the benefits of using derivatives, such as effective risk mitigation and risk transfer, have become increasingly important. Europe is by far the most important region for derivatives that have become a

major part of the European financial services sector.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group