Markets for Derivatives

In today’s column we will be discussing where derivatives contracts trade. There are basically two types of markets in which derivative contracts trade. These are exchange traded market and over-the-counter (OTC) market.

Exchange-traded derivative contracts (ETD): They are instruments that are traded via specialised derivatives exchanges or platforms on other exchanges. A derivatives exchange is a market where individuals trade standardised contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to serve as a guarantee.

Derivatives markets have been in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875.By the early 1900s India had one of the world’s largest futures industry. Derivatives on equity markets have seen huge growth since inception. Index futures were introduced in June 2000, followed by index options in June 2001. Futures and options on individual securities were introduced in July 2001 and November 2001, respectively.

Interest rate futures were introduced in June 2003 but, in contrast to equity derivatives, there has been little trading in them. One problem with these instruments was faulty contract specifications, resulting in the underlying interest rate deviating erratically from the reference rate used by market participants. Commodities and currency derivatives have also shown huge growth in terms of volume as well as value.

Over-the-Counter (OTC) derivatives: Due to standardisation and fixed contract specifications in exchange traded contracts, financial institutions began to develop non-exchange traded derivatives contracts for sophisticated investors. Instruments in the OTC markets are generally privately negotiated between market makers (or so-called swap dealers) and their clients.

The market is made up of banks and other highly sophisticated parties, such as hedge funds. Exact size of the OTC market is hard to determine because trades can occur in private without the activity being visible on any exchange. OTC derivatives can lead to significant risks. Especially counterparty risk has gained particular emphasis due to the credit crisis in 2008.Counterparty risk is the risk that a counterparty in a derivative transaction will default prior to expiration of the trade and will not make the current and future payments required by the contract.

Indian OTC derivatives markets, unlike many other jurisdictions, are well regulated. Only contracts where one party to the contract is an RBI regulated entity are considered legally valid in India. A good reporting system and a post-trade clearing and settlement system, through a centralised counter party, has ensured good surveillance of the systemic risks in the Indian OTC market.

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