The Structure of OTC Derivatives
INTRODUCTION
Derivatives are financial contracts whose value is linked to the price of an underlying commodity, asset, rate, index or the occurrence or magnitude of an event. The term derivative comes from how the price of these contracts is derived from the price of some underlying commodity, security or index or the magnitude of some event. The term derivative is used to refer to the set financial instruments that include futures, forwards, options and swaps. The combination of a derivative with a security or loan is called a hybrid instrument or alternatively a structured security and structured financing. Derivatives are traded in two kinds of markets: exchanges and OTC markets. Exchanges have traditionally been defined by “pit” trading through open outcry, but exchanges have recently adopted electronic trading platforms that automatically match the bids and offers from market participants to execute trades in a multilateral environment. The trading of derivatives (traditionally futures and options) on exchanges is conducted through brokers and not dealers.
TRADITIONAL DEALER MARKET – “BILATERAL NEGOTIATION”
The OTC markets have traditionally been organized around one or more dealers who “make a market” by maintaining bid and offer quotes to market participants. The quotes and the negotiation of execution prices are generally conducted over the telephone, although the process may be enhanced through the use of electronic bulletin boards by the dealers for posting their quotes. The trading process of negotiating by phone, whether end-user-to-dealer or dealer-to-dealer, is known as bilateral trading because only the two market participants directly observe the quotes or execution. This bilateral trading arrangement, from a regulatory point of view, is not considered a trading facility because it is not multilateral. However, it should be pointed out the bilateral negation process under this market arrangement is often highly automated. Dealers have direct phone lines between themselves and other dealers and their major customers, and this enables instantaneous communication so that a market participant can call up a dealer ask for quotes and then hang up and call another so as to survey several dealers in just a few seconds. A quick series of such calls can give an investor a view of the market that is not entirely different from a view obtained by observing a multilateral negotiating process.
“ELECTRONICALLY BROKERED MARKETS”
OTC markets have also adapted new electronic and networking technologies to their trading needs. One use of the technology is the formation of an electronically brokered OTC market through the use of an electronic brokering platform (sometimes referred to as a electronic brokering system). These electronic brokering platforms are essentially the same as the electronic trading platforms used by exchanges, and they create a multilateral trading environment. If this electronic brokering platform automatically matches bids and offers so as to execute a trade, the Commodity Exchange Act defines this trading as a trading facility because it is open to multilateral participation (i.e. the quoting of bid and offer prices and the execution of trades) by many parties. If it functions merely as an electronic bulletin board for the posting of bids and offers, then it is excluded from the definition.
“PROPRIETARY ELECTRONIC DEALER OR TRADING PLATFORM”
Yet another type of trading arrangement found in OTC derivatives markets is a composite of the traditional dealer and the electronic brokering platform in which an OTC derivatives dealer sets up their own proprietary electronic trading platform. Note the use of the term electronic trading, not brokering, platform because it is a dealing platform and does not function as a neutral broker. In this arrangement, the bids and offers are posted exclusively by the dealer; other market participants observe these quotes, and possibly also execution prices, in what is best described as a one-way multilateral environment. It is one-way, because no one but the dealer’s quotes are observable and those of the other market participants might at best be inferred from changes in the execution price. In this electronic trading, or dealing, platform, the dealer is the counterpart to every trade so that the dealer holds the credit risk in the market.
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