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1 1 (January 5, 2023)

handle is hein.crs/govekbp0001 and id is 1 raw text is: Congressional Research Service Informing qh1 legislative debate since 1914 Introduction to Financial Services: Derivatives Background A derivative is a contract that derives its value from an underlying asset at a designated point in time. For example, derivatives may be tied to physical commodities (such as wheat, cattle, oil, or gold), stock indices, or interest rates. A derivative's value fluctuates as the underlying asset's value or expected future price changes. Buyers and sellers of derivatives are not required to own the underlying assets. Derivatives come in several different forms, including futures, options, and swaps. Many firms use derivatives to manage risk. For example, a firm can protect itself against commodity price increases by entering into a derivative contract that gains value if the commodity's price rises. Southwest Airlines used such derivatives to implement a price hedging strategy in 2008 that allowed it to buy jet fuel at a low fixed price even as energy prices reached record highs. When used to hedge risk, derivatives can protect businesses (and sometimes their customers as well) from unfavorable price shocks. Speculators use derivatives to seek profits by betting on which way prices will move. Speculators may assume risks that hedgers seek to avoid. Such speculation may add liquidity to the market but may also concentrate risk (discussed below). Distinguishing between hedgers and speculators may be difficult, because a trade may encompass both speculative and hedging purposes. Although derivatives trading has its origins in agriculture, today most derivatives are linked to financial variables, such as interest rates, foreign exchange, stock indices, the creditworthiness of bond issuers, and, more recently, the price of certain cryptocurrencies. In June 2022, the Bank for International Settlements reported a $632 trillion global notional value for over-the-counter derivatives. Market Structure and Regulation Futures, options, and certain swaps are traded on exchanges regulated by the Commodity Futures Trading Commission (CFTC) or the Securities and Exchange Commission (SEC), depending on the underlying asset. Swaps were traded over the counter (OTC), meaning between parties without an exchange, until 2010, after which the Dodd-Frank Act required many to be cleared and traded on exchanges. Exchanges are centralized markets where buying and selling of various derivatives occurs. Traders who want to buy (or take long derivatives positions) interact with those who want to sell (or take short derivatives positions), making deals and reporting the agreed-upon prices throughout the day. In the OTC market, contracts are made bilaterally, typically between a dealer and an end user, and there is generally no requirement that the price, terms, or Updated January 5, 2023 even the existence of the contract be disclosed to regulators or to the public. Figure 1 shows the differences. Figure I. Exchange-Traded Versus OTC Derivatives Source: CRS. Derivatives can be volatile contracts with a high degree of leverage, which can result in big gains and losses. The exchanges mitigate credit risk through a third-party clearinghouse. Once a trade is made on an exchange floor (or electronic network), it goes to the clearinghouse, which guarantees payment to both parties. Traders' worries about counterparty default risk are reduced as the clearinghouse stands behind all trades. The clearinghouse ensures that it can meet its obligations by collecting daily margin-such as cash or Treasury securities-from trading counterparties if potential losses accumulate. The intended effect of margin is to prevent paper losses large enough to damage the clearinghouse in case of default. It is certainly possible for a trader to lose large amounts of money trading on the exchanges-but only on a pay as you go daily basis. In the OTC market, there is a network of dealers rather than a centralized exchange. Firms acting as dealers stand ready to take long or short positions and make money on the volume of trading by charging a spread, or fee, on each trade. The dealer absorbs the credit risk of customer default, and the customer faces the risk of dealer default. The OTC market has been dominated by a dozen or so large financial firms-broadly, the largest U.S. banks-and their foreign counterparts. In the OTC market, some contracts, but not all, require collateral or margin. Contract terms are negotiable. Risk Buildup and the Financial Crisis Prior to the 2008 financial crisis, there was no universal, mandatory system of margin in the OTC derivatives markets. This allowed large, uncollateralized losses to build up. For example, AIG, a major U.S. and international insurance firm, wrote about $1.8 trillion worth of derivatives, including credit default swaps, which guaranteed payment if certain mortgage-backed securities defaulted or experienced other credit events. As the financial crisis worsened, AIG was subject to contract- based margin calls that it could not meet. To avert

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