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1 1 (January 8, 2019)

handle is hein.crs/govxyc0001 and id is 1 raw text is: Introduction to Financial Services: Derivatives Background A derivative is a contract that derives its value from some underlying asset at a designated point in time. For example, the derivative may be tied to a physical commodity (such as cattle, wheat, or oil), a stock index, or an interest rate. Derivatives' prices fluctuate as the underlying assets' rates or expected future prices change, and neither a derivative's buyer nor seller need necessarily own the underlying asset. 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 increases in the price of a commodity that it uses by entering into a derivative contract that will gain value if the price of the commodity rises. A notable instance of this type of hedging strategy was a derivatives position taken by Southwest Airlines that allowed it to buy jet fuel at a low fixed price in 2008 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. Others use derivatives to seek profits by betting on which way prices will move. Such speculation may add liquidity to the market-speculators assume risks that hedgers seek to avoid-but may also concentrate risk (discussed below). Although derivatives trading has its origins in agriculture, today most derivatives are linked to financial variables, such as interest rates, foreign exchange, stock prices and indices, and the creditworthiness of bond issuers. The market is measured in the hundreds of trillions of dollars, and billions of contracts are traded annually. Growth in derivatives markets was explosive from 2000 until the end of 2008-the volume of derivatives contracts grew by approximately 500% by some measures-with some retrenchment after 2008. Market Structure and Regulation Prior to passage of the Dodd-Frank Act (P.L. 111-203) in 2010, futures and options were traded on regulated exchanges and swaps were traded over the counter (OTC). Futures contracts have long been traded on exchanges regulated by the Commodity Futures Trading Commission (CFTC), and stock options on exchanges regulated by the Securities and Exchange Commission (SEC). Exchanges are centralized markets where buying and selling interests come together. Traders who want to buy, or take a long position (longs), interact with those who want to sell, or go short (shorts), and deals are made and prices reported 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, Updated January 8, 2019 terms, or even the existence of the contract be disclosed to a regulator or to the public. Figure 1 shows the differences. Figure I. Exchange-Traded Versus OTC Derivatives Source: CRS. Derivatives can be volatile contracts characterized by a high degree of leverage, which can result in big gains and losses among traders. The exchanges deal with the issue of credit risk through a third-party clearinghouse. Once the trade is made on the exchange floor (or electronic network), it goes to the clearinghouse, which guarantees payment to both parties. The process is shown in Figure 1. Traders then do not have to worry about counterparty default: the clearinghouse stands behind all trades. The clearinghouse ensures that it can meet its obligations by collecting daily margin (sometimes called collateral)-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, as shown on the right side of Figure 1, there is a network of dealers rather than a centralized exchange. Firms that act as dealers stand ready to take either 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. All contract terms are negotiable. A trade group, the International Swaps and Derivatives Association (ISDA), publishes best practice standards for use of collateral, but compliance is voluntary. Derivatives in the 2008 Finanda Crisis Because there was no universal, mandatory system of margin, large uncollateralized losses built up in the OTC market in the run-up to the 2008 financial crisis. For example, AIG, a well-known example during the crisis, wrote about $1.8 trillion worth of derivatives, including httpsi/crsreports.congre-- -

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