Economics of Derivatives and Derivatives Markets –

Regulatory Framework for Stable and Efficient Growth

Lecture X

- OVERVIEW - Economics of derivatives and derivatives marketsDefinition (very brief)History of derivatives (brief)Purpose – positive economic functions

Price discoveryRisk shifting

-Hedging-Speculation-Unbundle and repackage risks

Public Interest Concerns (brief)Why derivatives? Comparison to banking, securities, and insurance.Market structures – not merely a black-box

Market makers and end-usersHedgers and speculatorsMarket balance or completenessExchange tradedOTCElectronic platforms: bulletin boards and automated order matching

Lecture X

- Definition - Definition of derivatives (simple but consistent with regulation)

A derivative is a transaction that is designed to create price exposure, and thereby transfer risk, by having its value determined – or derived – from the value of an underlying commodity, security, index, rate or event. Unlike stocks, bonds and bank loans, derivatives generally do not involve the transfer of a title or principal, and thus can be thought of as creating pure price exposure, by linking their value to a notional amount or principal of the underlying item.

Types derivatives products include- Forward- Futures- Options (American, European, barrier, path dependent)- Swaps (FX, interest rate, CCS, swaptions)- Hybrid securities (security with derivative attached, a.k.a. structured note)

Lecture X

- Definition -

Definition of a forward contract as a simple example

The simplest and perhaps oldest form of a derivative is the forward contract. It is the obligation to buy or borrow (sell or lend) a specified quantity of a specified item at a specified price or rate at a specified time in the future. A forward contract on foreign currency might involve party A buying forward at t1 (and party B selling) US$1,000,000 for Euros at $1.3405 on t91.

A forward rate agreement on interest rates might involve party A contracting on t1 to borrow (party B lending) $1,000,000 for three months (91 days) at a 2.85% annual rate beginning t91.

What does this achieve economically? Buying forward creates a long position in the underlying item (e.g. foreign currency). If the future market price (exchange rate) in the spot market appreciates in value, then the long position will gain in value much like that from owning the item outright. This creation of price exposure then facilitate hedging and speculation.

Lecture X

- History - Evidence of derivatives trading as early as 1750 B.C. in Mesopotamia

Holland in 1595 – creation of Amsterdam laws to facilitate transfer of title

Chicago Board of Trade, 1848 – trading in central market with standardized contracts

End of Bretton Woods monetary system – foreign exchange futures – 1971- lead to the creation of financial futures on foreign exchange rates in 1972 on CME and NYMEX

Black-Scholes-Merton Options Pricing Formula – 1973 – boosted the trading of options

CBOT Futures on Treasury securities in 1977 (Eurodollar interest rates at CME in 1981)

IBM- World Bank cross currency swap in August 1981

Kansas City Board of Trade – stock index futures in 1982 (CME’s S&P was two months later

By end of 2006, the notional amount of derivatives outstanding reached $486 trillion, and the annual trading volume of exchange traded futures and options reached $1,808 trillion.

Lecture X

- History - Evidence of derivatives trading as early as 1750 B.C. in Mesopotamia

Lecture X

- Usefulness - Price discovery

- Everyone can use price to inform their decisions about consumption and investment. Bond traders can look at corn, copper and oil prices to form inflation views, and various IR futures allow the creation of a yield curve. Thus an externality of information.

Risk shifting-Hedging – defined as reducing existing exposure to a risk-- Efficiency gain arising from shifting risk from one party to another that is better willing or able to bear it.-- Keep in mind that both sides of transactions might be hedging – does just shift to risk loving counterparty. In this case the risk is not only shifted but eliminated.-Speculation – defined as increasing existing exposure to a risk-- Speculators are thought to add economic value by helping to complete markets in which there is an imbalance between short- and long hedgers.-Unbundle and repackage risks-- e.g. the risk on a foreign currency bond can be decomposed into FX, IR and credit risk that are all priced and hedged separately – and the market value of the risk on the bond can be priced and hedged through options trading.

Cost of capital- improve upon inefficiencies or imperfections in financial markets- e.g. borrow at variable rate where credit premium is lower and then swap into fixed interest rate and end up with lower fixed rate borrowing cost than available by issuing fixed rate debt.

Lecture X

- Public Interest Concerns - This issue is addressed briefly here – will be address fully in Seminar IIMisuse

Outflank prudential regulation (regulatory arbitrage)Avoid taxation (tax arbitrage)Distort financial statement (creative accounting)

AbuseFraudManipulation

Systemic riskExcess risk taking – greater amount of risk taking for given amount of capital, the danger of which is the externality of risk taking.Non-transparency – no one knows how much open interest exists or who holds it

Lecture X

Lecture XI

- Why derivatives? - Comparison to banking, securities, and insurance

BankingNo principal – but FX swap is like a $ bank loan that is collateralized 100% with local currency. Malaysian government had to account for this in capital controls in 1997. Pre-paid forwards used by Enron and Chase to create credit through derivatives desks.

SecuritiesNo principal – but can generate the same total returns as equity or bond, e.g. the use of stock index futures to create portable alpha investment strategy

InsuranceOptions, like insurance, are priced as risk premium. But options are usually not capped, and insurance is based on damages from pre-existing risk exposure.

Lecture X

- Market structures – Market structures – not a black-box as is often assumed

Market participants- Market makers- End-users- Hedgers and speculators- Market balance or completeness

Exchange traded derivativesOTC derivatives

- Multilateral vs bilateral trading- role of brokers- Clearing house vs bilateral clearing- collateral practices

Electronic facilities: platforms (order matching), bulletin boards

- OVERVIEW - Public Interest ConcernsUse of derivatives and derivatives markets

Price discoveryRisk shifting

Misuse of derivatives and derivatives marketsRegulatory arbitrageAvoidance of taxationManipulation or distortion of financial statementsExcess risk taking in relation to capital

Abuse of derivatives and derivatives marketsFraudManipulation

Policy ImplicationsForeign exchange intervention in derivatives markets

Fixed exchange rate regime"Floating” exchange rate regime

Monetary policy intervention in context of interest rate derivativesHedging government revenues linked to commodity price fluctuations

- Use of derivatives and derivatives markets - Price discovery

This is often overlooked as a key economic function of derivatives markets.

Not overlooked by US law. Primary motive for regulating the markets is to protect the price integrity of the markets. It is in order to help ensure the accuracy and efficiency of these prices that law stricted prohibited fraud and manipulation.

Registration helps to prevent fraud by keeping criminals out of the markets. Registration requirements include background checks, competency test (equivalent of Series 7) and for financial firms it includes adequate capital and business model.

Reporting helps detect and deter manipulation. Reporting requirements include large trader reporting data.

Prior to being amended by the Commodity Futures Modernization Act of 2000, the Commodity Exchanges Act read as follows.

“‘Futures’ are affected with a national public interest. Such futures transactions are carried on in large volume by the public generally and by persons engaged in the business of buying and selling commodities and the products and byproducts thereof in interstate commerce. The prices involved in such transactions are generally quoted and disseminated throughout the United States and foreign countries as a basis for determining the prices to the producer and consumer of commodities and the products and by-products thereof and to facilitate the movements thereof in interstate commerce. Such transactions are utilized by shippers, dealers, millers, and others engaged in handling commodities … The transactions and prices of commodities on such boards of trade are susceptible to excessive speculation and can be manipulated, controlled, cornered or squeezed, to the detriment of the producer or the consumer and the persons handling commodities and products and byproducts thereof in interstate commerce, rendering regulation imperative for the protection of such commerce and the national public interest therein.” (Section 3 entitled “The Necessity of Regulation”)

Incidentally, the new section of the Act is entitled “Protection of the Public Interest” and reads more briefly and less literarily to convey a similar economic message.

The transactions subject to the Act are … are affected with a national pubic interest by providing a means for managing and assuming price risks, discovering prices, or disseminating pricing information through trading in liquid, fair and financially secure trading facilities.

- Use of derivatives and derivatives markets -

Risk shifting1. Hedging: reducing existing risks2. Unbundling risks: decomposing risks associated with an investment. Derivatives allow different risks to be traded and priced separately so that

investors need not hold all the risks associated with an investment in order to have the risks and returns of the other risks. For example, an investors may want the credit risk and interest rate risk of an emerging market bond but not the exchange rate risk and can eliminate it by hedging.

3. Similarly, derivatives can be combined with traditional capital instruments in order to tailor a security to the preferences of investors or to tailor the nature of the liabilities of a security issuer to their ability to hold to risk. For example, Chilean corporations borrow abroad through dollar loans or notes where they can get long term debts. and then swap back into the peso to avoid exchange rate risk.

4. Derivatives can be used to improve upon the inefficiencies in capital markets. For example, borrows pay lower credit spreads on variable rate debt and can then swap into fixed rate obligations less expensively than borrowing at fixed rates.

- Misuse of derivatives and derivatives markets - 1. Regulatory arbitrage

2. Avoidance of taxation

3. Manipulation or distortion of financial statements

4. Excess risk taking in relation to capital

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- Abuse of Derivatives - 1. Fraud – costs everyone in the market by undermining confidence,

and costs most everyone as greater expenses are incurred to avoid or detect it. There are many types of fraud: front-running, wash trades, sharp trading practices.

2. Manipulation

1) Protecting the integrity of market prices.

In Section 3 of the Act entitled, “Necessity for Regulation,” it stated that futures are "affected with a national public interest." "The prices in such transactions are generally quoted and disseminated throughout the United States... for determining the prices to producer and consumer of commodities and the products and by-products thereof and to facilitate the movements thereof in interstate commerce."

In short, these prices are important because they are used not only by those directly involved in the market but also by producers and consumers throughout the economy. Fraud and manipulation are therefore a matter of pubic interest – not just a problem for those who are defrauded or suffer the losing end of the manipulation – because they threaten the integrity of the markets i.e. of the price discovery process.

 

2) Providing a safe and sound market for risk management.

Derivatives markets provide economically useful tools for hedging and risk management. The extent of their use depends on their affordability, and leverage contributes to their affordability. Leverage also encourages speculation and greater risk taking. Capital and collateral (called margin for exchange traded derivatives and securities) requirements are the pillars of financial market safety and soundness. They function by providing a buffer against losses and a disincentive for excessive risk taking. Like securities markets and the banking sector, a well regulated derivatives market should have capital and collateral requirements that are commensurate with the level of exposure to market risk and credit losses. While this will increase the cost, i.e. lower the affordability of OTC derivatives, the market should benefit overall from the improved investor confidence in the marketplace.

3) Small distortions in market prices can have a large impact on the economy.

 Keep in mind that manipulation does not have to be grand in the old fashion way, but can consist of small changes in prices. If prices of winter wheat are off only 3 cents a bushel, and U.S. farmers produce and sell at home and for export 1,612 million bushels, then it will be a $48.36 million cut in income for the farmers on the winter wheat crop alone. That same 3 cents applied to the 9.5 billion bushels of corn would affect income by $285 million – almost six times the impact. That small price change would equal 1% of the nation’s net farm income for all crops. Similarly, consider a manipulation of 3 basis points (0.03%) on Treasury securities. If that has to be paid by the government on all outstanding Treasury securities held by the public, then it would cost the Treasury and hence U.S. taxpayers about $1 billion annually.

The ability of the government to detect and deter fraud and manipulation is dependent on the reporting requirements of market participants. Market prices, trading volume, open interest and larger trader positions are the minimum information needed to maintain adequate market surveillance. This is the standard for exchange traded derivatives and is similar for the stock and government bond market.

Information-based manipulation:

This involves insider trading or making false reports on the market. An example of the former is the manner in which Enron executives made early moves to cash out their employee stock options and sell their security holdings. An example of the latter is illustrated by the way Wall Street firms associated with Enron made “buy” recommendations to their customers and the wider market while enhancing their firms’ profits from holding Enron securities, underwriting and other business relationships.

 

Action-based manipulation:

This involves the deliberate taking of some actions that changes the actual or perceived value of a commodity or asset. For example, managers of a firm short the firm’s stock and then announce the loss of an important contract or the closing of factories. After they profitably cover their short positions by buying at lower prices, they negotiate new contracts or reopen the factories. Note that these two examples show that action based manipulation can be combined with insider trading. Similarly, but without insider information, investors may take a position on the stock and then pursue legislation or regulatory changes that might be passed to change the value of the assets.

 

Trade-based manipulation:

This is the classic case of either unexpectedly amassing a large position in the market, or more likely using one market to capture the gains from creating a price distortion in another interrelated market. How does this work? In the latter case, a manipulator acquires a large long position in the derivatives market in crude oil by entering forward or swap contracts for future delivery or future payments based on the future price of oil. If the derivatives positions were transacted through the OTC market, then neither the government nor any other market competitor would be able to observe the total position of the manipulator. Then the manipulator goes into the spot or cash market for crude oil and amasses a large enough inventory of oil (and also contracts to sell it to buyers who will not resell it) in order to push up the present oil price. This raises the value of the long derivatives positions so that they can be offset or unwound profitably. Then if the manipulator can sell off the amassed inventory without incurring substantial losses, the manipulation will be successful. Keep in mind that the manipulator does not have to buy all the oil in the world, but merely that portion that is to be delivered in the market that is linked to the derivatives contracts. (See the oil price manipulation case below.)

EXAMPLES:

The CFTC charged two futures traders with manipulating the futures and options market for U.S Treasury bonds in October of 1992. The two sold 13,000 bond futures contracts (roughly $13 billion in notional value) and bought 31,000 put options (roughly $31 billion in notional value). The traders were arrested on the trading floor, expelled from the Chicago Board of Trade, fined $2.25 million by the CFTC and faced criminal charges.  

In June of 1993, the CFTC charged that the financial firm Fenchurch used exchange traded derivatives called futures in conjunction with a large share of the cash market to manipulate the interest rate on special collateral repurchase agreements on 10-year U.S Treasury notes and profit by forcing short position holders to deliver a more expensive Treasury security to fulfill the futures contract. Towards the expiration date of the futures contract, Fenchurch held a long futures position of 12,700 contracts (approximately $12.7 billion in notional value) or 76% of the open interest in the market. The repo rate on the 10-year note fell below 0%, i.e. reached negative

EXAMPLES:

Tosco won a settlement claiming that Arcadia Petroleum (a British subsidiary of the Japanese firm Mitsui) engineered an elaborate scheme to manipulate oil prices in September of 2001 through the use of OTC derivatives and a large cash market position to corner the market in Brent crude oil. (Brent is a blend of crude oils pumped out of the North Sea and shipped from a terminal at Sheffield Island off Scotland). As a result, the price of Brent Crude soared between August 21st and September 5th and pushed its price to a premium over West Texas Intermediate crude oil (WTI). WTI, which is a higher quality oil, is normally priced about $1 above Brent, but during this period Brent sold for more than $3 above WTI. This artificial price hike occurred at a time of widespread strikes and social protest in Europe.

 

Dated Brent, which acts as a price marker for many international grades, is physical crude traded on an informal market, rather than a regulated futures exchange. This lack of regulation poses problems for oil producers and consumers seeking a fair price, said Robert Mabro, director of the Oxford Institute for Energy Studies and a leading Brent expert.

 "There are regular squeezes in the Brent market," Mabro said. "In the trading community, people are fed up. This general view that you can do whatever you like in an informal market is okay, as long as you regulate the market a bit. But if it's a free-for-all, you're back to the cowboy age."

 A typical Brent squeeze involves a company quietly building a strong position in short-term swaps called contracts for difference, or CFD's, for a differential not reflected in current prices. The company then buys enough cargoes in the dated Brent market to drive the physical crude price higher, which boosts the CFD differential, Mabro said.

 The company may lose money on the physical side, but it's more than compensated from profits on its offsetting paper position in the short-term swaps market, Mabro said.

 "The whole trick is to collect more money in CFDs than you lose on the physical squeeze," Mabro said. "People seem to do it in turn. It depends on who's smart enough to move in a way that nobody notices until it happens."

- Policy Implications - Main Policy Implications Questions:

1. Volatility: does the presence of derivatives markets add to existing market volatility (especially in exchange rate)

2. Does the use of derivatives to exchange rate risk result in capital outflows that negate the benefits of capital inflows?

3. Do derivatives markets weaken the ability of a central bank to manage exchange rate policy by giving potential attackers greater leverage?

Other policy issues:1. How does it affect monetary policy intervention in context of interest rate

derivatives2. Can derivatives be used effectively by Treasuries or development

agencies to hedge government revenues linked to commodity price fluctuations

- OVERVIEW - Regulatory Framework for Stable and Efficient Growth- Registration requirements: how and why this is important, including anti-fraud and stability issues.- Reporting requirements: how and why this is important, including anti-fraud, detect and deter manipulation, transparency, and market surveillance.- Capital requirements: how this can be applied to derivatives, with comparison on balance sheet items.- Collateral requirements: comparison of exchange-traded to OTC derivatives markets, including - Orderly Market Rules. Some examples are:

Position limitsPrice limitsDesignated market makers with requirements to maintain bid/ask quotesStandards for contract design (there are many dimensions to this issue)

- Clearing procedures: multilateral clearing house (central counterparty) compared to bilateral netting and clearing.- Macroeconomic Policy Issues: e.g. foreign exchange intervention, hedging national budgets from commodity price fluctuation, debt management.

- Conceptual Overview –

Economic Rationale for Regulation:

Regulation arises from market imperfections such as externality, incompleteness, destructive competition, natural monopoly and MAC events that invoke national security.

Each feature in the following regulatory framework is linked to some market imperfection that creates need to improve upon what would be a competitive market outcome.

-Registration Requirements -

Registration requirements: how and why this is important, including anti-fraud and stability issues.

FIGHTING FRAUDEconomic incentives include those for committing fraud. Financial markets cannot do an adequate job of policing themselves from fraud. Efforts to do so would suffer from lack of authority, free-rider problems, possible protectionist motives and the usual problems of injustice associated with militias, posses, mobs and armed gangs. So the task is best assigned to legitimate public authority.

Registration is key step in fighting fraud by requiring key personnel with fiduciary and investment management responsibilities to submit to i) background checks to see whether their criminal past, such as convictions for fraud, would disqualify them from certain responsibilitiesii) competency exams, e.g. series 7, for responsible individuals to prove they are know what they are doing – right or wrongiii) adequate capitalizationiv) good business plan

SURVEILLANCEProvides supervisory authorities with a census of who is involved in market activities.Can be combined with record keeping requirements to oblige participants to maintain audit trail.

-Reporting Requirements - Reporting requirements: how and why this is important, including anti-fraud, detect and deter manipulation, transparency, and market surveillance.

Markets function most efficiently when all participants are fully informed, yet economic incentives encourage firms to hoard information. Disclosure or reporting requirements are needed to discourage information, and do so in a timely and consistent manner, so that participants can adequately analysis of information. For example, the 1933 and 1934 securities acts in the US focused on establishing reporting requirements to improve market transparency. Another US example is the 1936 Commodity Exchange Act.

Also, there is another externality to the information content in prices or the price discovery process. The externality arises from the use of the information by people who are not directly involved as market participants. Bond traders look to commodity futures prices in order to form views on inflation and in turn prices in the fixed income market. Ag producers in remote or distant areas are affected by prices determined in Chicago, New York or London. If those prices are distorted, then all the other make erroneous decisions based on the false prices. Thus there is a public interest in protecting the integrity of market prices.

Yet another externality is the nature of information as a public good. Because I am informed by some information it is not prevent you from being informed. If we are all equally informed then eliminates the benefit for one or few have exclusive access to information. This takes away the benefit to the few but it makes the market more efficient.

-Reporting Requirements - Everyone says they are for transparency, but there is no agreement on what it is or how to get there. Here are some specifics.

1. Financial institutions, including dealers, brokers, exchanges and electronic trading facilities, must report details of their derivatives trading activities to supervisory authorities. The authorities will in turn provide aggregated information to the broader public. The proprietary details will be for the eyes of the authority to detect vulnerabilities as they emerge and pricing pressures. (Like exchanges reporting market prices, trading volume and open interest, this will facilitate the production of pricing and other key market information for all participants and the public). This is not necessarily costly – merely CC-ing the authorities on the confirm documents will inform them.2. Large trader reporting requirements – informs surveillance authority of large positions in the market in order to help detect and deter market manipulation.3. Quarterly and annual reporting of the financial condition of key financial institutions such as dealers, brokers, exchanges and clearing houses, will help detect the build-up of vulnerabilities in the financial system.

- Capital Requirements - Capital requirements: how this can be applied to derivatives, with comparison on balance sheet items.

There is an externality from risk taking. Some who are not involved in the investment decision and will not benefit from the returns, will be negatively impacted if the investment fails. Consider the employees of firms in developing countries whose securities prices are clobbered by recent contagion from subprime market disruptions. Their losses are not costs to subprime market participants and thus are externalities to those market participants.

It is not immediately feasible to reunite the social and price costs of the market disruption. However what is feasible is to constrain or govern the risk taking of firms and individuals so that their risk taking is in governed by the proportion of capital they put at risk. Capital requirements set the minimum standard for putting capital at risk in order to pursue higher risk and returns.

Otherwise there is a serious moral hazard as limited liability business organization gives firms a free put with a zero strike price. Otherwise there will be fallout from the economic impact of larger and reckless failed investment strategies. The capital requirement is not just a solvency condition but a governor or constraint – though a prohibition – on the investment decisions of key financial institutions.

- Collateral Requirements - Collateral requirements: comparison of exchange-traded to OTC derivatives markets, including

Like capital requirements, collateral requirements are aimed at governing risk taking so as to reduce potential externalities.

Collateral is especially important to derivatives markets because there is great leverage and collateral has the effect of governing the extent of (or the degree of) the leverage.

Collateral also helps manage counterparty credit risk that builds up in the process of active OTC derivatives trading.

- Orderly Market Rules - Orderly Market Rules. Some examples are:

• Position limits• Price limits• Designated market makers with requirements to maintain bid/ask quotes• Standards for contract design (there are many dimensions to this issue) such as economic usefulness, avoidance of manipulation or excess volatility, • Minimum tick size or bid/ask• Prohibition against certain misconduct such as front-running, wash trading and the like• Suitability or ‘know thy customer’ requirements

- Clearing Issues - Clearing procedures: multilateral clearing house (central counterparty) compared to bilateral netting and clearing.

Clearing House• Multilateral• Offers AAA counterparty risk – deep capitalization provides protection• Collateral is paid up front• Daily, and if needed interday, market to market with margin adjustments reduces credit risk• Offers complete legal netting through novation• Providing trading efficiency through lower back office costs• Concentrates credit risk in a single financial institutions and thus warrants close attention

Bilateral OTC clearing• Post trading activity - confirmation, clear and settle - is done principal to principal• No collateral requirement, and industry practice is uneven and often below par. Refco advertised lowest margins in the market.• Typical arrangement: i) counterparties allowed to trade under a threshold before posting collateral; ii) a variety of assets are allowed to be posted as collateral (some not necessarily liquid); iii) if counterparty gets into trouble then they are ‘super-margined’ and must post additional collateral (thus acts as crisis accelerator).• Disperses risk to some degree, although concentration in few derivatives dealers reduces the benefit of dispersion.

- Policy Implications - Policy Implications

Foreign exchange intervention in derivatives marketsFixed exchange rate regime"Floating” exchange rate regime

Monetary policy intervention in context of interest rate derivativesHedging government revenues linked to commodity price fluctuations