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Outline how exchange-traded and over-the-counter markets work and weigh the pros and cons of each.

FRM® Part I · Financial Markets and Products · Introduction to Derivatives · FRM1.FM.4.b

The idea

Exchange-traded derivatives are standardised in size, maturity and delivery, and trade on an exchange where a clearing house becomes the counterparty to both sides. The clearing house controls credit risk with initial margin and daily marking to market, so losers pay variation margin each day. Prices are transparent and positions are easy to close out. Over-the-counter derivatives are negotiated bilaterally between dealers and clients, so terms can be tailored exactly to the exposure. They carry counterparty credit risk, less transparency and usually less liquidity. Since the 2008 crisis, standardised OTC derivatives are increasingly cleared through central counterparties, and non-cleared trades face margin requirements. The trade-off to remember is customisation versus credit protection and liquidity.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which feature is characteristic of exchange-traded derivatives?

  1. Terms negotiated bilaterally to fit each client's exact needsWhy not: Describes over-the-counter contracts; exchange contracts are standardised.
  2. Standardised contract terms with a clearing house standing between buyer and seller - correct
  3. No margin or collateral required of either side to a tradeWhy not: Margin and daily settlement are central to exchange trading, not absent.
  4. Each party bears credit risk directly on the other partyWhy not: In exchange trading the clearing house is the counterparty, so credit risk is mostly borne by it.

Exchanges list standardised contracts and a clearing house becomes the counterparty to both sides, using margin and daily marking to market. Bilateral customisation is a feature of OTC markets.

A harder one

A trader goes long 10 futures contracts of 100 units each at 50.00 per unit, posting total initial margin of USD 5,000. Settlement prices on the next two days are 48.00 and 49.00. Assuming no withdrawals and no margin call, the margin account balance after the second day is closest to:

  1. USD 6,000Why not: Reverses the signs of the daily settlements, treating a price fall as a gain for the long.
  2. USD 3,000Why not: Stops after day 1 and ignores the day-2 gain of USD 1,000.
  3. USD 4,000 - correct
  4. USD -1,000Why not: Reports only the cumulative profit and loss and leaves out the initial margin deposit.

Day 1: (48 - 50) x 1,000 = -2,000. Day 2: (49 - 48) x 1,000 = +1,000. Balance = 5,000 - 2,000 + 1,000 = 4,000. Daily marking to market moves cash between margin accounts each day.

The hardest tier

A dealer has three trades with three different counterparties. Their mark-to-market values to the dealer are +12, -7 and +3 (USD millions). With no netting across counterparties, its credit exposure is the sum of the positive values. If all three trades were novated to one central counterparty (CCP) that nets them in a single netting set, and ignoring margin, the dealer's exposure to the CCP would be:

  1. USD 15 millionWhy not: Gives the bilateral figure, the sum of the positive values, ignoring the multilateral netting a CCP provides.
  2. USD 12 millionWhy not: Takes only the largest single positive trade rather than the net of all three.
  3. USD 8 million - correct
  4. USD 22 millionWhy not: Sums the absolute values of all trades, which counts the negative trade as exposure.

Bilateral exposure = 12 + 3 = 15. Netting at the CCP = 12 - 7 + 3 = 8. Multilateral netting through central clearing reduces credit exposure, which is a key benefit of CCPs.

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