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.
The underlying asset 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.
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.
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, in determining the overall value of such legislation versus the potential negative consequences to the market and to users of OTC derivatives to hedge risk, 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 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 please see the Securities Industry and Financial Markets Association (SIFMA) OTC derivatives page; and for global developments, 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 increased by 2% during the second half of 2009—to $615 trillion—overall gross market values decreased by 15%, after a 22% contraction in the previous six-month period.
Notional amounts of outstanding foreign exchange and interest rate contracts grew over the second half of 2009, while CDS and commodity contracts declined—by 9% and 21%, respectively.
The biggest decline in gross market values over the latest six-month period was seen in CDS—which went from $2.9 trillion to $1.8 trillion.
Showing the effects of the financial crisis and market fears over the use of most types of derivative instruments, gross market values of outstanding OTC derivatives contracts have been declining since the second half of 2008—going from $32 trillion in December 2008 to $25 trillion by June 2009, and dropping further to $21 trillion by the end of 2009.
Data is from the Bank for International Settlements (BIS), June 2010.
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