Law
The contract is governed by English law and includes provisions
regarding force majeure, trade emergency and embargoes.
CLEARING AND REGULATION
Clearing
LCH guarantees financial performance of all IPE contracts regis-
tered with it by its clearing Members. All IPE Floor Member com-
panies are either members of LCH, or have a clearing agreement
with a Floor Member who is a member of LCH.
Regulation
The IPE is regulated in the UK by the Financial Services Authority
(FSA) as a recognised investment exchange (RIE) under Part XVIII
of the Financial Services and Markets Act 2000 (FSMA). Further,
in April 2003, the IPE received no-action relief from the US
Commodity Futures Trading Commission under Sections 5 and 5a
of the Commodity Exchange Act to make all of its contracts avail-
able in the UK on the ICE Platform during the course of the entire
trading day.
In accordance with the FSMA, all IPE General Participants based in
the UK will be authorised and regulated by the FSA. Where General
Participants are incorporated overseas, they will be regulated by
the relevant regulatory authority in that jurisdiction.
Source: International Petroleum Exchange.
Derivative products can be of the same type and category, i.e. energy
future, index options but it is important to stress that it cannot and
must not be assumed that they are the same.
Over-the-counter derivatives
OTC derivatives as noted are negotiated or non-standardised products.
The advantages are the ability to tailor the product to meet a specific
need or to transact in a single trade the required hedge or exposure
strategy.
Over-the-counter derivatives are a large market, estimated by the
International Swaps and Derivatives Association (ISDA) as being in tril-
lions of US dollars in value. The combined OTC and exchange-traded
markets can be reasonably said to be the largest market in the world.
Derivative products 31
How do OTC derivatives differ from exchange-traded products?
We have seen how exchange-traded products are standardised into
contracts such as futures or options and that they are actively traded
in the secondary market, i.e. someone who buys a futures contract
can sell it in the market to someone else.
However the standardisation of the contracts does cause some prob-
lems when it comes to their use as hedging instruments, as the amount
of an asset to be hedged is often different to the size of the derivative
contract which is of course fixed by the standardisation process.
Also the hedger may want to hedge the position for say 12 months
and the asset may be a combination of different classes of the asset.
Example
A fund manager has a portfolio of UK equity shares in a combination
of FTSE 100 stocks and smaller companies and wants to hedge the
portfolio for twelve months. The value of the portfolio is £2 425 000
and the FTSE 100 Index Future is currently trading at 5823.5.
If the fund manager decides to use the FTSE 100 Index Future there
are some problems.
First, the most liquid contract will be the nearest maturity, a
maximum of three months away. Therefore the futures position will
need to be ‘rolled’ over through different maturities in the course of
the 12-month period.
Secondly, the FTSE 100 Index Future is based on the 100 Stock
Index and will therefore move in price according to the movement in
the 100 stocks and will not take into account the change in value of
the smaller companies not in the index. The hedge correlation is
therefore not right.
Thirdly, the number of contracts required to hedge the portfolio
would be:
Portfolio/£10 Index Point 2 425 000/£10 5823.5
2 425 000/58235 41.64 contracts
You cannot trade 41.64 contracts so the fund manager must trade
either 41 or 42 contracts. In either case the portfolio is not precisely
hedged.
It is because of these kind of issues that hedgers often look to
arrange an deal with a counterparty, usually a bank if it is a financial
product that can be tailored to meet the precise hedging requirement.
32 Clearing and settlement of derivatives
On the other hand the fund manager knows that there is a coun-
terparty risk in an OTC transaction and there is usually no clearing
house guarantee, possibly a capital adequacy issue as a result of the
exposure and that it is usually difficult or expensive to trade out of
the position if the fund manager changes their mind.
Therefore both OTC and ETD derivatives can and often are used by
the same organisation and the choice will depend on the strategy, risk
appetite, liquidity, cost and ability to close the position if desired.
Characteristic Derivative product
OTC ETD
Contract Tailored, negotiated, flexible Standardised quantity, grade
terms and confidential and maturity
Delivery Negotiable dates and very Defined delivery dates and terms
often go to delivery but majority of contracts are
closed out before delivery
Liquidity Negotiated so can take time Usually very good for main
and can be limited by contracts
available counterparties
Credit risk Risk is with counterparty Clearing house becomes
although some OTC counterparty to all trades
products are now cleared and manages risk through
by clearing houses daily revaluations and
Collateral is also used to margin calls
reduce the risk
With the terms of OTC derivatives being totally negotiated, the oper-
ations function is different to that of the exchange-traded products.
Instead of standardised settlement processes and procedures, like
daily variation margin (VM) calls, we have periodic or event-driven
settlement.
We can illustrate this, as we look at some of the products traded
over-the-counter in more detail later in the book.
To summarise derivative products we can say that derivatives are
widely used instruments designed to transfer risk, at the same time
offering opportunities to arbitragers, speculators, corporate treasurers
and investors like fund managers and private clients.
Derivatives can be either exchange-traded, where they are standard-
ised products, or, where they are negotiated and bespoke. Some types
of derivative instruments are available in both forms. As versatile prod-
ucts, whether traded on an exchange or over-the-counter they have dif-
fering characteristics, uses and of course settlement conventions.
Derivative products 33
The clearing and settlement process will be either via a clearing
house (exchange-traded and some types of OTC transactions) or from
counterparty to counterparty (OTC). The clearing house provides a
central guarantee and manages the counterparty risk as well as the
settlement and delivery processes. Documentation and events tend to
drive the settlement process in OTC transactions.
As with all types of transactions in financial markets, reconciling
trade details, positions, cash movements, etc. is absolutely vital.
With derivatives the problems of errors are magnified by the gearing
or leverage characteristics so that any unresolved errors and unrec-
onciled trades or positions are potentially going to lead to significant
loss.
That said, many millions of derivative transactions take place daily
around the world without problems occurring because the user under-
stands the product and the processes involved.
Derivative markets continue to grow steadily and in some locations
spectacularly. New products are constantly being designed and
requested and the infrastructure in the industry changes constantly
to meet these challenges.
34 Clearing and settlement of derivatives
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