Exchange Traded Derivatives

Suitability of Derivatives to be Traded on Exchanges

There are several big advantages to having derivative contracts traded on exchanges, although it is not simply a matter of preference, wishing that certain derivatives contracts be traded on exchanges instead of over the counter.

There are certain types of derivatives contracts, such as futures contracts, that can be very well suited to trading on exchanges, and certain types, such as the type that large institutions trade in, that simply aren’t.

Whether or not a certain type of derivatives contract is even suitable for exchange trading isn’t such a simple matter as saying that it is better to trade financial assets on exchanges. This is in spite of quite a few people thinking that we should regulate over the counter derivatives contracts on exchanges.

In order to properly understand what the potential for this might be and whether not one or the other form of trading is more suitable, we need to look into the aspects of each, starting with exchange trading.

Exchange traded derivatives have been around for a long time, to the early days of exchanges, and derivatives exchanges actually led the way as far as exchange trading in general goes. Exchange type trading, with standardized contracts, goes back even further, to the days even before the concept of money, where commodities were traded in central locations for fixed contract amounts.

The main purpose of organizing trading on an exchange is to promote liquidity, and this is the main purpose of markets generally as well. There are other benefits that exchanges offer, but none even come close to the importance that greater liquidity offers.

Qualitative Standardization

The goal of derivatives exchanges is to promote as much homogeneity as practically possible, which makes the assets that are traded as widely appealing as they can be. Should one want to trade a certain asset, it should not matter whether or not one contract should be preferred over another, or one may fit what a trader is looking to buy or sell better than another.

The commodities market provides some perfect examples of this concept in action. There are two components of standardization in trading, qualitative and quantitative ones.

If we are looking to buy or sell a contract based upon gold for instance, and you can choose among different standards of gold purity, 24K, 18K, 14K, 10K for example, or even some random level of purity between these levels, this is going to make trading the contract much more difficult.

What happens here is that only those who are looking to trade the particular purity of gold are going to be interested in your particular contract to essentially bet on the future movement of the price of gold, and this serves to make the market for gold futures more fragmented.

The way the gold market works today, with almost all of it being on paper, may at least serve to reduce the impact of all of this, as if you’re not ever planning on taking possession of any gold at any point or delivering any, the quality of it shouldn’t really matter.

There is some gold that does change hands in gold futures markets though, and these people do care, but the real issue here is that by fragmenting markets for assets by separating them by qualities too much, this means that each market will have considerably less liquidity.

If we had 5 futures markets for gold, this is going to dilute the liquidity in all of them, and some might not even generate enough interest to be able to trade it without big spreads. This runs completely counter to the goal of all markets and whenever we can consolidate assets into more defined markets, such as we do with the trading of gold bullion, this is a big benefit for sure.

There are cases, such as with different types of crude oil, West Texas and Brent for instance, that we do need to separate assets this way, but this distinction is only made when necessary. With other commodities, the qualitative nature of the assets are similar enough that they do become standardized, with the quality of the goods in one contract being similar enough with another that we can treat them the same way.

Quantitative Standardization

If we traded derivative contracts without quantitative standardization, this would also fragment markets. If traders wanted a given amount of an asset, and the amount offered was considered unsuitable, too large or even too small for the trader to bother with, this is going to be a problem.

So, in addition to specifying a certain standard of quality, making whatever distinctions that need to be made in order to classify the asset being traded as similar enough, we also need to standardize the size of the contracts traded.

This is the reason why futures exchanges trade standard contracts, and full sized contracts tend to involve a fairly large portion of the asset traded with a fairly large valuation, in the tens of thousands of dollars typically.

Many retail investors may not have the means to trade full contracts, which has led to the formation of mini contracts, worth a tenth of a full contract. These smaller contracts do benefit from standardization as well, and actually add rather than take away from the liquify of the market by adding trades that would not otherwise have been made due to inaccessibility of traders to full contracts.

One is not limited to trading larger amounts than contracts offer, as one then just needs to place orders for multiple ones, as many as one desires provided that the amount is being offered in the market.

While this does not allow for trades for fractions of contracts, 2.5 for instance, the benefits of offering them in standard sizes is more than enough to make up for this shortcoming.

Managing Counterparty Risk

The other main function of exchanges is to manage the risk that the parties in a derivatives contract will not fulfill their obligations, called counterparty risk. There are many risks associated with trading, and some can be managed better than others, but being successful in a trade and not having the other party settle the trade as agreed is one we certainly want to avoid.

It is not that there isn’t any counterparty risk at all with trading derivatives on exchanges, but the exchanges do serve to keep this in check, keeping it low enough that it’s not generally a concern.

With private contracts, there may be various amounts of counterparty risk particular to the type of contract, the parties, and future business and market conditions, and when parties contract with each other directly, they are on their own basically when it comes to default risk.

Counterparty risk is more of a concern with derivatives, because it is not a matter of just having the other party turn over assets within 3 business days of the trade, assets that they already possess at the time.

With derivatives, nothing is held, and the parties simply engage in contracts which place financial obligations upon them based upon the changing values of an underlying asset. The parties must not only have the means now to meet these financial obligations, they must also have the means to meet future ones, which is certainly more difficult to manage.

Exchanges do set certain requirements that makes this all easy, for instance with traders needing to put down good faith deposits, and not being allowed to get too far behind before the trade becomes closed forcibly.

The Derivatives Trading Must Fit the Model

Whether or not a certain type of derivatives contract fits the model well enough for it to make sense to have them traded on exchanges depends on the situation.

It is not, as some believe, just a matter of getting the contracts to fit the exchange model, as when they do not, this can mean that the trade simply does not happen if we somehow disallow private contracts in certain circumstances.

Those who deal in huge contracts with very high notional values may not want to break them up that way, but this is the least of the concern here. The quest for qualitative standardization is the bigger issue, where parties may require that the terms of the contract be more specific to their particular needs.

Trades between large financial institutions, especially with swaps, tend to be of this nature, and when you’re dealing with billions of dollars worth of assets and terms that may fit the needs of this trade but perhaps not fit so well with the needs of different trades between other institutions, we cannot just force the parties to standardize beyond their needs.

When we cannot standardize, which often can be pretty challenging and even not make sense, this does make the contracts less or even much less liquid, but the nature of the trade is that more liquidity just isn’t possible.

This means that we don’t even lose a theoretical amount of liquidity because there isn’t even any of that. A derivatives contract can even be unique, one that no one else would ever want to take on, but one that the parties who did engage in it required to best suit their needs.

So, there is a trade-off here between utility and liquidity, and if we do require a more party specific contract, that is going to make it less appealing for others, and therefore more difficult to trade.

With huge over the counter derivatives contracts, the usefulness of the terms of the contract will take precedence, while with exchange trading, liquidity will be the primary goal.

With this said, there may be some cases that certain types of over the counter derivative contracts could benefit from at least more standardization if exchanges were more flexible to accommodate them.

In order to actually seek efficiency, which is the whole idea behind this, it is the exchanges and not the parties that need to adapt. The goal of compete standardization that exchanges seek is a fine one with certain types of trading, but we may benefit from a more flexible view of the role of exchanges such that they may perhaps provide their benefits to some over the counter trading.

Even though these benefits would be of a lesser degree than traditional exchange trading offers, any benefit is worth considering, and even just seeing their performing the roles of bringing buyers and sellers together and vetting them to some degree based upon stability and reliability is worth looking at more.

Perhaps we could be well served to look to provide a more hybrid form, one that looks to seek out the benefits of exchanges without impacting the utility of customization excessively.

The lion’s share of the notional value of derivatives contracts occurs off exchanges, privately in other words, and if there are enough advantages to having more of this traded on exchanges, if we offer this and the benefits are actually there, traders will come.

For the smaller retail traders, as well as medium sized ones, exchange traded derivatives clearly offer a number of significant benefits and will continue to play a significant role in derivatives trading.