According to the International Swaps and Derivatives Association (ISDA), a derivative is a risk transfer agreement, the value of which is derived from the value of an underlying asset. More simply, a derivative is a contract between two parties where one party agrees to take on the risk of losses associated with a particular asset—such as a physical commodity or an agreed amount of currency.
National amounts outstanding of over-the-counter (OTC) derivatives, (in US$ billions , 2009-2011)
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Data is from the Bank for International Settlements (BIS,) 2011
Gross Market Value of over-the-counter (OTC) derivatives, (in US$ billions , 2009-2011)
The underlying asset from which a derivative derives its value may be a physical commodity, an interest rate, a company’s stock, a stock index, a currency, or virtually any other tradable instrument upon which two parties can agree. An over-the-counter (OTC) derivative is a bilateral, privately-negotiated agreement that transfers risk from one party to the other.
Derivatives can either be over-the-counter—meaning a one-off, private, customized contract—or exchange-traded—meaning a standardized contract that is traded through an exchange.
Since 1998 the Bank for International Settlements (BIS) has published semi-annual data on outstanding OTC derivatives contracts for G10 countries and Switzerland, and the data is included in a global survey conducted every three years with data from 54 central banks and monetary authorities.
According to BIS, the objective of the semi-annual survey is to obtain comprehensive and internationally consistent information on the size and structure of derivatives markets in the G10 countries and Switzerland. It includes notional amounts outstanding and gross market values, and helps to monitor the evolution of particular OTC derivative market segments.
The Push for Transparency
Privately-negotiated derivatives are frequently criticized for a perceived lack of transparency, according to the ISDA research paper “Transparency and over-the-counter derivatives: The role of transaction transparency .”
This, in turn has put pressure on global policymakers to increase legislation geared at reducing perceived opaqueness in the OTC derivatives market.
“Characterizations such as “murky,” “opaque,” and “anonymous” appear regularly in the financial press. The apparent implication is that financial markets would be more efficient, and society would be better off, if over-the-counter derivatives moved to a higher level of transparency,” noted the paper.
According to the ISDA research paper, proposed legislation aimed at increasing transparency must be weighed against a number of factors, including: liquidity, market efficiency and price discovery, volatility, transaction costs, and market stability.
Proponents of increased legislation governing transparency, however, cite examples during the financial crisis—such as global insurer AIG receiving US bailout funds to cover outstanding derivatives contracts and the default of Lehman Brothers—to exemplify the importance of transparency into managing risks within the OTC markets.
Final legislation is still pending in many global jurisdictions. For more information on the latest developments in OTC Derivatives legislation in the US and across the world, please see the ISDA Regulatory Committee updates and issues page .
There is a big difference between the notional amounts of outstanding OTC derivatives contracts—the face value of the underlying asset—and the gross market value of the outstanding contracts themselves.
The notional amount is the actual value of the asset for which the contract is written, but parties to a derivative contract are seldom required to pay out the full value of the asset, hence the notional amount outstanding is seen as a poor reflection of the actual risk. The gross market value, in contrast, is the total amount paid by companies for outstanding contracts.
Although overall notional amounts outstanding decreased during the second half of 2011—to $648 trillion from $707 trillion in the first part of the year—overall gross market values increased substantially, continuing on the same upward path of the previous year.
Notional amounts of outstanding foreign exchange and interest rate contracts grew over the second half of 2011, while commodity contracts and CDS both declined.
The biggest decline in gross market values over the latest six-month period was seen in equity-linked contracts —which went from $708 billion to $679 billion.
Showing a reprieve from the worst of the financial crisis, gross market values of outstanding OTC derivatives contracts grew in 2011, to over 27 trillion, after declining throughout 2010 and dipping below $20 trillion at the beginning of the year.
Data is from the Bank for International Settlements (BIS,) 2011.
Amounts outstanding of over-the-counter (OTC) derivatives, by risk category and instrument, (in US$ billions , 2009-2011)
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- Bank for International Settlements (BIS): OTC Derivatives Statistics
- Definitions: International Swaps and Derivatives Association (ISDA)
- Financial Times, Why OTC derivatives must be cleared, Gertrude Tumpell-Gugerell, June 2010
- International Swaps and Derivatives Association (ISDA): transparency and over-the-counter derivatives: The role of transaction transparency, 2009.
- Larry Harris, Trading and Exchanges: Market Microstructure for Practitioners. New York, Oxford University Press, 2002.
- Securities Industry and Financial Markets Association (SIFMA) Homepage