Exchange Traded Derivatives
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Create account Login Subscribe. Venkatachalam Shunmugam 19 March The exchange-traded derivatives market has been exchange traded derivatives market rapidly, particularly in the decade preceding the global crisis. This column discusses the various policies available for mitigating the downside risks and argues that the dynamic nature of the market calls for the continuous evolution of regulation and regulatory tools.
Over the past three decades derivatives have become critical to the existence of transparent, exchange-traded markets the world over. Particularly in the last few years, the exchange-traded derivatives segment has witnessed remarkable growth driven by path-breaking innovations in products and technology — largely spurred by competition.
The benefits have been many. Derivatives have helped a diverse base of economic stakeholders manage exchange traded derivatives market risks in exchange traded derivatives market most cost-effective way — no small feat exchange traded derivatives market this era of rapid global information flow.
Moreover, by facilitating a transparent convergence of vast information from a broad base of exchange traded derivatives market, exchange-traded derivatives also enable efficient price discovery.
This not only helps the immediate stakeholders make informed decisions, it exchange traded derivatives market gives a cue to the policymakers formulating policies aimed at maintaining economic stability and, by extension, socio-political stability. While dimensions such as electronification, leverage, and a robust clearing mechanism of exchange-traded derivatives markets have provided participants with easier access to the exchange-traded derivative platforms, they have also, at the same time, exposed these markets, their efficiency, and their respective immediate and distant stakeholders i.
These risks can be classified into two categories:. Exchange-traded derivative markets for various asset classes perform two primary economic functions:. However, their performance is vulnerable to a slew of risks in these very markets.
The risk to the price discovery efficiency of these markets arises from price manipulation by participants either taking exchange traded derivatives market positions or taking advantage of leverage that these markets provide. As a result, the prices that transparently emanate from exchange-traded platforms mislead the real economy more indirectly or directly make the process of risk management on these platforms costlier for the stakeholders of the real economy.
At times, participants lose trading interests in these asset classes leading to the failure of exchange-traded markets to discover right prices of underlying asset classes. Contract design also plays a critical role in making the price signals from exchange-traded derivatives useful to the stakeholders of the real economy. It requires that adequate efforts are taken to properly identify the relevant underlying market and that the derivative contract specifications are in line with those of the exchange traded derivatives market cash market practices.
Additionally, it is necessary that the platforms make sure that their products are keeping up with the changing market dynamics. For example, the problem of non-convergence between cash spot and futures prices of wheat on futures contract expiry in select US commodity futures platforms was essentially a problem of contract design.
If the process of price discovery does not function in alignment with underlying market fundamentals, it may pose a threat to the relevance of derivatives markets to stakeholders of the real economy.
Besides, financial default risk and physical delivery default risk have the potential to impair the price risk management mechanism. Such defaults as they happened on the exchange traded derivatives market default swap and collateralised debt exchange traded derivatives market markets in the US have the potential to bring to halt functioning of an entire economy through the domino effect of related participants in related asset classes on over-the-counter markets.
But this attempt actually works or goes against the basic principles of economics. Therefore, such individual apparently rational actions could turn out to be collectively irrational i.
What, among other things, differentiates human beings from animals is their ability to think about their future and anticipate what it could hold for them. However, if their expectations turn negative, the exchange traded derivatives market could be due to the influence of these expectations rather than by the changes in the real economy.
While it is natural that human emotions get expressed in markets, the fact that these result in extreme price swings— unconnected from the fundamentals — harms both the financial market and stakeholders.
It is the job of regulators to limit such swings. But what is a rational level? Maybe history can guide. Rational decisions at the individual level can turn into collectively irrational behaviour, as discussed above.
This can lead to systemic risks even in exchange-traded derivative markets, irrespective of the asset classes these markets operate for. In reaction market regulators have used various tools to prevent individual or collective irrationality from building up in these markets from time to time.
However, the use of these tools vanished in derivative markets in several developed economies in recent years — they were viewed as a hindrance to the natural operation of business cycles. Figure 1 shows that regulators worldwide have been using various tools to rid markets of different risks.
Of various tools, dynamic effective utilisation of margins and its variants such as additional margins and special marginsalongside mark-to-market margins, hold the key to containing risks of price manipulation and financial default, which add to systemic risk. Besides, position limits and price limits can exchange traded derivatives market be used to rein in the possibility of price manipulation.
While the use of various regulatory tools and the degree of regulation vary from market to market based on the basis of maturity, the dynamism that characterises markets calls for continuous evolution exchange traded derivatives market regulation and regulatory tools. Financial markets International finance. Mapping the two-way risks in exchange-traded platforms Venkatachalam Shunmugam 19 March The exchange-traded derivatives market has been growing rapidly, particularly in the decade preceding the global crisis.
The risks with derivatives While dimensions exchange traded derivatives market as electronification, leverage, and a robust clearing mechanism of exchange-traded derivatives markets have provided participants with easier access to the exchange-traded derivative platforms, they have also, at the same time, exposed these markets, their efficiency, and their respective immediate and distant stakeholders i.
These risks can be classified into two categories: One relates to the unregulated participation, which could lead to imperfect functioning of derivative markets; and the other pertains to the wrong signals that these markets could provide to the real economy because of their imperfect functioning see Figure 1. Risks to and from derivatives markets Risks to and from derivative markets Exchange-traded derivative markets for various asset classes perform exchange traded derivatives market primary economic functions: Price discovery, and; Price risk management.
Adequate and evolving regulatory tools — a must Rational decisions at the individual level can turn into collectively irrational behaviour, as exchange traded derivatives market above.
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