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IMC IE Chapter 9 > 9.7 Derivative markets > Flashcards

9.7 Derivative markets Flashcards

1
Q

What is the main derivatives exchange in the UK?

A

ICE Futures Europe

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2
Q

List 4 things ICE Futures offers

A
  1. Contracts on financial assets
  2. Energy products
  3. Agricultural products
  4. Softs
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3
Q

Which regulator is ICE Futures Europe recognised by?

A

The FCA

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4
Q

How can one trade on ICE Futures Europe?

A

Trading can only be conducted by, or through, members of the exchange.

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5
Q

Which clearing house does ICE Futures Europe use and for what?

A
  • ICE Futures Europe uses ICE Clear Europe (a clearing house recognised by the Bank of England) to clear, register and arrange settlement on its contracts.
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6
Q

How can member firms of derivative exchanges act?

A

Like equity and debt markets, member firms of derivative exchanges may act either as principal to a trade and/or as agent.

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7
Q

Explain dealing (principal trades).

A

By acting as principal, the firm is taking a position itself, i.e. ‘running a book’. The aim is to make a turn on the trade (buy low, sell high). When acting as principal, the trade will be assigned to the firm’s house account. These traders are sometimes referred to as ‘locals’.

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8
Q

Explain broking (agency trades).

A

The firm may act as agent on behalf of a client. In these circumstances, the firm will not take a position but instead earns commission on the trade. When acting as agent, the trade will usually be assigned to a segregated account which is separate from the firm’s own account. Some clients may, however, consent to their trades being allocated to a non-segregated account.

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9
Q

What happens when some members of an exchange execute a trade for other members of an exchange?

A

These trades will usually be allocated, or ‘given up’ to the house account of the originating firm. A trade is ‘given up’ so that the originating firm can clear the trade on behalf of the client.

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10
Q

What is meant by the term dual capacity?

A

Members that can act as either agent or principal to a trade, are said to have dual capacity.

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11
Q

Where does the term open outcry trading stem from? Can you name a market where open outcry trading still takes place?

A

Historically, most derivatives trading took place face-to-face on a market floor. Traders gathered in pits and ‘cried’ out prices, hence the term open outcry trading. The London Metal Exchange (LME) is a market where open outcry trading still takes place.

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12
Q

What form of trading have derivative exchanges tended to move towards?

A

Rather like the securities markets, derivative exchanges have tended to move towards screen-based order book trading. Trading takes place electronically based on prices displayed on screens

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13
Q

Do you need an exchange floor for screen-based order book trading?

A

There is no requirement for an exchange floor as trading takes place remotely via computers. ICE Futures Europe uses such an order driven system.

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14
Q

How does execution occur on derivative exchanges that use screen-based order book trading?

A

Execution occurs in very much the same way as we say on the LSE SETS.

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15
Q

Explain the legal side of trading derivatives.

A

When trading derivatives, the participants are entering into legally binding contracts to perform an action (make or take delivery of an asset) at some point in the future. To ensure the contracts are legally binding, the exchange will construct the contract that is agreed. To ensure the maximum liquidity, the exchange will standardise these contracts; this means every member is trading an equivalent contract within an underlying asset class.

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16
Q

Derivative exchanges set down rules that dictate the requirements of members. What is the main rule?

A

Requirements on reporting trades.

17
Q

Define over-the-counter (OTC) contracts.

A

Over-the-counter (OTC) contracts are one-to-one (bilateral) agreements between two counterparties where the contract specifications are completely flexible and non-standardised.

18
Q

What is a great benefit of over-the-counter (OTC) contracts?

A

A great benefit of this is that, when hedging, the contract used can be specifically tailored to the requirements of the underlying position, whereas when using standardised exchange-traded contracts hedges need to be continually rebalanced or rolled on from month to month.

19
Q

How are OTC deals conducted?

A

OTC deals are not conducted on a formal exchange, but directly via telephone and screen-based displays. There is less likelihood of a central guarantor (like LCH.Clearnet or ICE Clear Europe) to ensure ultimate fulfilment of the contract, so the creditworthiness of both counterparties is extremely important.

20
Q

What requirements are OTC trades subjected and not subjected to?

A

OTC trades are not subject to the MiFID pre-trade and post-trade transparency requirements. However, there is some requirement to make reports. This was most notably enforced in Europe under the European Markets and Infrastructure Regulation (EMIR).

21
Q

What are some difficulties associated with OTC contracts?

A

Because OTC contracts are tailor-made, they are more difficult to trade than exchange-traded contracts. This also makes them difficult to value, and price information is not always available.

22
Q

Why do OTC contracts also require substantial documentation?

A

To ensure that the terms of each contract are clear, accurate and agreeable to both sides of the trade.

23
Q

What is the role of the International Swaps and Derivatives Association (ISDA)?

A

To oversee the OTC derivatives market and produce standardised formats on which OTC documentation can be based.

24
Q

What is the benefit of an OTC?

A

They are a product that can be designed to meet the exact requirements of market participants.

25
Q

Summarise the difference between OTC and Exchange Traded products in regards to:

  • Contract terms
  • Liquidity
  • Margin
  • Regulation
  • Counterparty Risk
  • Reporting
  • Price
  • Hedging
A

OTC

Traded on exchange

Contract termsBespoke: Tailored to meet the needs of the investorContract specifications standardised by the exchangeLiquidity

Can be limited leading to

slower execution

Excellent on majorcontractsMargin

Normally no margin

Collateral process

Margin normally requiredRegulation

Less stringent regulation of

products

More stringent restrictions on who may invest in them

Exchanges subject to significant regulation

Counterparty risk

Typically exposed to default risk

No member default riskdue

toclearing house

Reporting

Confidentiality

Market transparency

Price

Negotiated or request for quote (RFQ) systems

Best execution

Hedging

Specific hedging requirements can be met

Hedges based on standardised contracts need to be actively managed

26
Q

Summarise the difference between OTC and Exchange Traded products in regards to:

  • Contract terms
  • Liquidity
  • Margin
  • Regulation
  • Counterparty Risk
  • Reporting
  • Price
  • Hedging
A

Here is a summary of OTC contracts:

  • The contract terms are bespoke as they are tailored to meet the needs of the investor.
  • The liquidity can be limited leading to slower execution.
  • There is normally no margin, it’s a collateral process.
  • There is less stringent regulation of products and more stringent restrictions on who may invest in them.
  • Counterparty risk: typically exposed to default risk.
  • The reporting is confidential.
  • The price is negotiated or request for quote (RFQ) systems used.
  • Specific hedging requirements can be met.

Here is a summary of exchange-traded contracts:

  • The contract specifications are standardised by the exchange.
  • The liquidity is excellent on major contracts.
  • Margin is normally required.
  • Exchanges are subject to significant regulation.
  • Counterparty risk: no member default risk due to clearing house.
  • There is market transparency in reporting.
  • The best execution price is used.
  • Hedges based on standardised contracts need to be actively managed.
27
Q

How are OTC trades typically conducted and what is the benefit of this approach?

A

OTC trades are typically done bilaterally between two parties who negotiate and agree terms with each other. This eliminates the need for an exchange, potentially lowering the cost and giving much more flexibility in what details can be written into the contract.

28
Q

What is one of the major disadvantages of OTC contracts?

A

One of the major disadvantages of OTC contracts is not having access to an exchange’s risk management systems, such as the clearing house and its margining and settlement systems.

29
Q

What have regulators tried to improve in OTC contracts?

A

There has been a great effort in recent years by regulators to improve risk management in the OTC market.

30
Q

What 3 new requirements does the European Markets Infrastructure Regulation (EMIR) impose on those who trade OTC derivatives and who do they apply to?

A
  1. To clear OTC derivatives that have been declared subject to the clearing regulation through a central counterparty (CCP)
    - The Public Register for the Clearing Obligation identifies the classes of OTC derivatives that central counterparties are authorised to clear
  2. To put in place risk management procedures for those OTC derivatives that are not centrally cleared
  3. To report derivatives to a trade repository
    - Repositories include the DTCC Derivatives Repository and Bloomberg Trade Repository

All three obligations apply to financial counterparties.

31
Q

The clearing and risk management obligations apply, in addition, to certain non-financial counterparties who are above clearing thresholds. What are these thresholds?

A
  • €1bn in gross notional value for OTC credit derivative contracts
  • €1bn in gross notional value for OTC equity derivative contracts
  • €3b in gross notional value for OTC interest rate derivative contracts
  • €3bn in gross notional value for OTC foreign exchange derivative contracts
  • €3bn in gross notional value for OTC commodity derivative contracts and other OTC derivative contracts not defined in the earlier 4 requirements.
32
Q

Who do the reporting obligations apply to?

A

The reporting obligation applies to all participants.

33
Q

What is the rule for trades that are captured by mandatory clearing or are reported to a repository?

A

Trades that are captured by mandatory clearing or are reported to a repository must also meet post-trade disclosure obligations. These are met by publishing trade details through an Approved Publication Arrangement.

34
Q

What has happened to EMIR in the UK post-Brexit?

A

Following Brexit, the UK has onshored EMIR, known as UK EMIR. While most of the obligations under UK EMIR are substantively the same as those under EU EMIR, there are a few exceptions. These include reporting derivative transactions entered into on or after 1 January 2021 to one of the following trade repositories authorised and registered under UK EMIR: ICE Trade Vault Europe Limited, UnaVista Limited, DTCC Derivatives Repository Plc or REGIS-TR UK Limited.

35
Q

Which body is responsible for the registration and supervision of trade repositories?

A

FCA

36
Q

What derivative regulation is in the US?

A

In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010, building on the Commodities Exchange Act 1936 and the Commodity Futures Modernisation Act 2000, imposes similar requirements. These will be enforced by the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC).

37
Q

What is the International Financial Reporting Standards (IFRS 9)?

A

IFRS 9 replaces IAS 39, and dictates how financial instruments, such as derivatives, are valued and recognised in the company’s financial statements. This is particularly relevant to derivatives as, particularly in the case of futures, there is no initial outlay involved.

38
Q

Explain what is meant by the term ‘Fair value through profit and loss’

A

Derivatives, and investments with embedded derivatives, should be recognised at fair value, with changes in fair value recognised through profit or loss in the reserves. In this way they are marked-to- market at the time of producing the financial statements and any profit or loss is recognised appropriately

IMC IE Chapter 9 (8 decks)

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