Regulation Of Derivatives Markets

Question 1

Briefly explain the concept of derivatives and where they can be traded

Answer 1

1. Derivatives can be traded either an organised exchanges or an OTC market
2. In exchange traded markets - derivatives are standardised (follow same set of rules) with special delivery or settlement terms
3. Negotiation between traders was traditionally conducted by shouting on the trading floors.
4. Now, electronic trading is the main trading system.
5. In the UK, all derivative exchanges are RIEs. The FCA regulates the financial soundness and conduct of all derivatives exchange

Question 2

What are the main features of trading derivatives in both exchange-traded markets and OTC markets?

Answer 2

1. Trading is done on ICE Futures Europe or the London Metal Exchange
2. Once a trade has been matched - it’s registered with a clearing house which becomes the CCP to the contract
3. Clearing house for ICE Futures Europe is ICE Clear Europe.
4. Clearing house for London Metal Exchange is LME Clear
5. If an ICE Futures member is trading on behalf of a client - separate back-to-back contract is established between the member and the client
6. ICE Futures members act as principles are not agents for the clients. (They trade for themselves and should take full responsibility)
7. The clearing house ONLY manages risk and is not a counterparty nor has any involvement in the member-client relationship.

Question 3

What can be traded on ICE Futures Europe and London Metal Exchange?

Answer 3

1. ICE Futures Europe is for commodity derivatives
2. LMS is for metals

Question 4

What are some of the concepts around holding a position in an ICE Futures Europe or London Metal Exchange future or option?

Answer 4

1. Traders deposit an initial margin at the clearing house before trading on ICE Futures Europe or the London Metal Exchange (LME).
2. The Initial margin is a set amount of cash/ liquid assets required by the clearing house - ensures the trader can meet the contract terms if needed.
3. Initial margins for futures contracts are fixed, meaning they stay the same.
4. Initial margins for options can change based on market conditions. These positions are checked daily, and any profits or losses are settled.
5. Profits and losses from price changes are added to/ deducted from the trader’s margin account.
6. If a trader’s margin balance falls below the required level, the clearing house demands more funds to restore it. This extra payment is called “variation margin.”
7. The clearing house settles margin payments with clearing members, who then settle with their clients.
8. All positions are revalued daily until they are either delivered or offset.
9. To close (offset) a contract - trader must take the opposite position (buy if you sold, sell if you bought) and notify the clearing house. Once closed, the initial margin is returned to the trader.

Question 5

In simple terms, explain how trading occurs on ICE Futures Europe and LME

Answer 5

Traders must deposit an initial margin to trade, and their profit/loss is adjusted daily.

If their margin falls too low, they must top it up.

They can close a trade by taking an equal and opposite position, after which the margin is refunded.

Question 6

This flashcard is just for understanding purposes only. Do not need to memorise.

This is with regards to trading on ICE Futures Europe or LME

Answer 6

Example: Trading Oil Futures on ICE Futures Europe

1. Opening the Trade (Lodging Initial Margin)
   A. Buy 1 oil futures contract on ICE Futures Europe at $80 per barrel.
   B. Clearing house requires an initial margin of $5,000 for this contract.
   C. You as a trader deposit $5,000 into your margin account to start trading.
2. Daily Price Changes (Mark-to-Market)
   A. The price of oil rises to $85 per barrel the next day.
   B. Your profit is $5 per barrel
   C. Say if 1 contract = 1,000 barrels, your profit is $5,000
   D. This profit is added to your margin account.
   E. New balance in the margin account is now $10,000 ($5,000 initial margin + $5,000 profit).
3. Price Drops and Margin Call (Variation Margin Required)
   A. The following day, the price falls to $75 per barrel.
   B. Your loss is $10 per barrel (or $10,000 total).
   C. Your margin account drops to $0, which is below the required $5,000 initial margin.
   D. The clearing house issues a margin call for $5,000 to bring your account back to the required level (this extra payment is called variation margin).
4. Closing the Position (Offsetting the Trade)
   A. You decide to sell an oil futures contract at $75 to close your position.
   B. Since you bought at $80 and sold at $75, you lost $5 per barrel (total loss: $5,000).
   C. The clearing house returns your initial margin of $5000.
   D. BUT, because you lost $5,000, your account balance is now $0.

Question 7

Explain the concepts around trading derivative trades IN EXCHANGE-TRADED DERIVATIVE MARKETS

Answer 7

1. Trades Are Public and Cleared –
   A. Every trade is publicly reported and processed through a clearing house.
2. CH acts as a middleman to ensure smooth transactions.
3. Clearing House Guarantees Trades –
   A. If the seller cannot pay (defaults), the clearing house steps in to complete the trade, so the buyer doesn’t lose out.
4. Risk is Managed with Margins –
   A. To protect itself, the clearing house checks value of trades and adjusts account balances daily (marking to market).
   B. Traders must keep enough funds (margins) in their accounts to cover potential losses.

Question 8

Explain the concepts around trading derivative trades IN OTC DERIVATIVE MARKETS

Answer 8

1. Bilateral Nature of Trading –
   A. Trading happens directly between two parties, without using an exchange.
   B. Both sides agree on the terms of the trade.
2. Negotiable Contract Terms –
   A. The details of the trade, like delivery time, quantity, price, and location, can be discussed and agreed upon between the two parties.
   B. Everything is flexible.
3. Transaction Communication -
   A. Trades can be made over the phone or using other methods of communication, instead of through an exchange platform.

Question 9

What was the purpose of introducing MiFID II/ MiFIR and EMR for OTC derivatives trading?

Answer 9

1. Increase transparency.
2. Reduce systemic risk.
3. Trading derivatives on an exchange, MTF or OTFs - subject to MiFID II transparency rules for pre-and post trade transparency

Question 10

EMIR requires entities that enter into any form of derivative contract to -

What are the requirements for EMIR here for someone entering into a derivative contract?

Answer 10

1. Report Derivatives –
   A. When you enter into a derivative contract, you must report it to a trade repository.
   B. The trade repository keeps records of all trades.
2. Risk Management for Bilateral Trades –
   A. For OTC derivatives (those not cleared by a CCP), you need to follow new rules for managing risks, like ensuring proper margining (money held to cover potential losses).
3. Clear through a CCP where necessary –
   A. If an OTC derivative must be cleared through a CCP (due to mandatory rules), you need to do that to reduce risks of default.
4. Trade on Venue for Certain Derivatives – A. Some derivatives must be traded on a regulated platform (venue).
   B. This is specified in the Derivatives Trading Obligation (DTR) rules.
5. BoE maintains the Public Register for Clearing Obligation that identifies the classes of OTC derivatives that CCPs are authorised to clear.

Question 11

What are Trade Repositories (TRs)?

Answer 11

1. Registered under UK EMIR or UK SFTR
2. Trade repositories (TRs) are official organizations that follow UK rules (like UK EMIR or UK SFTR) to manage information about trades.
3. Collect and Maintain Records – keep track of and store information about derivative contracts and securities financing transactions (SFTs) from traders and market participants.
4. Provide Information to Authorities – TRs give regulators access to contract details, so they can monitor markets and spot any potential risks to the financial system.

Question 12

What is UK EMIR and UK SFTR?

Answer 12

1. UK EMIR - onshored European market infrastructure regulation.
2. UK SFTR - on shorted securities financing transaction regulation.

Question 13

Explain the structure with regards to the trade depositories under the UK EMIR?

Answer 13

1. Trade depositories safeguard and manage assets on behalf of others.
2. Under the UK EMIR - four trade depositories registered with the FCA. These include:
   A. DTCC derivatives Repository
   B. ICE Trade Vault
3. There are 129 Datta fees to be reported for each transaction. They are divided into two groups.
   A. G1: information on counter parties involved
   B. G2: details on the characteristics of the contract

Question 14

What are some concepts around the new regime for Systematic Internalisers for non-equity financial instruments (bonds/ derivatives)?

Answer 14

1. Providing Quotes –
   A. SI’s must give quotes/ prices when a client asks for them.
   B. These quotes must be available to all clients equally without favoring any one client over another.
2. Transaction Size –
   A. When SIs enter into a trade with a client, they need to do so at or below a specific size for the particular instrument. B. They can also set limits on how many transactions they will do at a specific price.
3. Client Selection –
   A. Discretion - While SIs have to follow certain rules, they have some freedom in choosing which clients they want to do business with, based on commercial decisions.