Over the Counter Derivatives

The world of derivatives trading overall is a huge one. Most people don’t realize the scope of these markets, which involve several times more assets than the stock and bond markets put together. The derivatives market these days dwarfs everything, including the total amount of wealth in the world.

While we usually think of derivatives markets as exchange traded derivatives, futures and options, the great majority of the notional value of derivatives contracts occurs off the exchanges, with what we call the over the counter market.

Over the Counter DerivativesThere are over the counter markets for just about every kind of asset, including stocks. The trading of stocks has been taken up primarily by stock markets, and the ones traded over the counter are stocks that are not listed on an exchange, due to their not meeting the requirements of exchanges.

Over the counter stocks can therefore be seen as the minor leagues of stock trading, with the more substantial stocks being traded on exchanges across the world. Futures and options trade on exchanges, while the forex and bond market are entirely over the counter, as well as the huge world of over the counter derivatives.

In spite of the popularity of exchange trading, the over the counter market overall is larger, and much larger in fact. Since this all occurs behind the scenes for the most part, and doesn’t really attract much media attention. They aren’t markets that the public participates in directly, and over the counter markets tend to be more under the radar than exchange trading, which is very much in the public view.

People pay more attention to exchanges because they have more of a vested interest, as people do invest most of their money in the stock market primarily, and they also use stock indexes as a general barometer to judge where the “market” is at and even how the economy may be performing and headed.

The Enormous Size of the Over the Counter Derivatives Market

Make no mistake about it though, the over the counter market is much bigger and much more significant, although people only really tend to get a taste of this when things really go sour, such as what happened with the subprime mortgage crisis of late.

We’re in an era where securities play a much bigger role than they ever did, and securitization by way of over the counter derivatives has now become the biggest market in the world by far, with a value that has approached a quadrillion dollars at times by some estimates. When you’re talking about amounts that are several times greater than all the money in the world, this is truly a mind bending amount.

One may wonder how this is even possible, and the reason is that derivatives are not assets but positions taken upon the movement of assets, and these positions can and do well exceed the value of all the money in the world because they deal with debt to a large degree

Debt involves future obligations to be paid back with future assets, and derivative contracts create more debt on top of the existing debt when they are leveraged. Institutions can take a position in the bond market for instance where the contract can involve 10 times the money they put up for instance.

When you take assets based upon future cash flows, like debt, and then borrow to take even larger positions, there is a multiplier effect here and some big notional amounts can become involved. The real money supply these days is almost all credit, with only a small portion being what we consider to be real money, currency or money in the bank, which in itself well surpasses the traditional understanding of what money is.

Institutions make deals with each other to move debt around and to create more debt, and debt is indeed king in today’s economies. The value of derivative contracts isn’t part of the money supply though, even though it is based upon it, but like all derivatives, it involves leveraged positions based upon future movements of things.

Why Exchanges Are Not That Suitable for Over the Counter Derivatives

Exchanges are limited to being intermediaries in high volume transactions, and assist in increasing the volume of the transactions they process and oversee. Things like stocks, futures, and options are well suited to this, because we can standardize these trades, in lots of stocks or futures contracts, and allow the parties to easily exchange their positions in markets.

Over the counter derivative contracts are a different sort of beast though. They tend to be larger by orders of magnitude than your average trade on exchanges or even the largest trades you will ever see on one.

Exchanges promote liquidity, and what is traded on exchanges need to have the means to be liquid, in other words there has to be a lot of supply and demand for what is traded to make sense to have the asset listed and traded on an exchange.

While there are indeed some thin listings on exchanges that don’t trade more often, one could if the demand is there, and there are minimum requirements to be listed, including liquidity requirements.

Over the counter derivatives are much more like private companies, who have shares but they aren’t traded by the public, and only garner interest when someone is looking to put together a big business deal, selling the company, taking over another one, attracting big investors, and so on.

Private companies can go public though if they choose, but the nature of over the counter derivatives contracts preclude that due to the very limited number of potential market participants.

These huge contracts only really occur between large institutions, the ones that can do deals involving billions of dollars at a time, and that’s the size of the contracts we’re talking about here.

A Matter of Fit

Where investors will fit their strategies to the contracts, like for instance what we see with futures contracts, over the counter derivative contracts require that the contracts themselves fit the objectives of the contracting parties.

The needs with these contracts can vary and can even be such that the terms of it will only fit the parties themselves, and therefore can be entirely illiquid. These contracts are traded as well often times, but with such a limited scope, the number of potential participants will remain very small and nowhere near what would be required to make sense of having these trades made on exchanges.

Over the counter derivative contracts also tend to be very complex, and this is the exact opposite of what suits an exchange, where the goal is to look to simplify things to make what is traded more widely appealing.

Someone may buy and sell positions in a commodity, standard lots with standard terms, being tailored to the widespread demand out there for these things.

Getting the terms to fit the needs of contracting parties is the fundamental goal of over the counter derivatives contracts, for instance with one party hedging an exposure to something like interest rate changes and another party taking on the risk because they can handle it better.

In theory at least, we could seek to standardize some of this, but the fact that institutions do not want to bother with such things and prefer to engage in contracts that better suit the size and scope of what they are looking for is going to be a big issue that will stand in the way of such things.

Over the counter trading is therefore not only the best fit for these contracts, it is also the preferred way to trade them, and therefore we may expect that this style of trading will continue, in spite of regulators preferring exchange trading.

Over the Counter Derivatives Trading is Very Challenging to Regulate

While it may be possible to take a portion of over the counter derivatives trading and move it over to exchanges, for most of the trading that goes on here, it is simply neither practical nor efficient to do so.

Regulators are therefore limited to looking to regulate these trades and markets from the outside so to speak, which is at least possible in theory, although considerably more challenging than regulating other markets.

Over the counter derivatives are once again quite complex. Unlike futures trades for instance, where you really end up with a zero sum game regardless of where the price of the underlying asset ends up, it is far less clear what future events will do to derivative trades.

What we look to do with exchanges is to limit counterparty risk, requiring that margin rules be strictly enforced, and this for the most part limits this risk to amounts that are not generally a concern.

With over the counter derivatives, it’s much, much harder to determine whether a position in the market involves excessive risk, and even the people handling these trades, who are presumably the experts, can make some very big mistakes here in risk assessment and management.

Given the importance of the over the counter derivatives market in the overall economy, we cannot over regulate either, because that’s going to fail to assign the risks that are already present efficiently, and can itself promote default risk.

We need to be able to hedge enough, and with these contracts, there is a hedger and a speculator, so we don’t want excessive speculation without due regard to risk either.

A balance therefore must be sought, which can be pretty simple to implement with more simple contracts, but these contracts are far from simple, and that only adds to the challenge.

This is the challenge that regulators face, although just knowing how much risk is out there, or even the size of this market, is a start. We aren’t even at the point where we can even say how big the over the counter derivatives market even is, other than making some educated guesses, as this is still a dark pool market for the most part.

That’s the easy part though, to put together a scheme where the size of this market could be tracked with accuracy, but just knowing how much is only a small part of the challenge. Knowing what the risks are with any meaningful degree of certainty is the real challenge, and to be able to achieve the right balance, this is something we need to be at least reasonably accurate with.

Over the counter derivative trading is and will remain a very large part of our economy. The era we are in now is mostly described as the Information Era, but it is also the Securitization Era, and all these securities add up to a lot indeed.

We need to do our best to look to keep the risks involved to a minimum, even though this minimum will remain pretty significant, but this is the nature of the beast. The risks are already out there, and over the counter derivative trading for the most part merely seeks to manage them, but this management does require the right amount of skill and foresight.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: eric@marketreview.com

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.