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There are three primary ways of negotiating and trading derivatives:
  • Over-the-counter (OTC) derivatives
  • Centrally-cleared derivatives
  • Exchange-traded derivatives
Figure DH 1-2 summarizes the key differences between OTC derivatives, centrally-cleared derivatives, and exchange-traded derivatives.
Figure DH 1-2
Differences between OTC, centrally-cleared, and exchange-traded derivatives
OTC derivatives
Centrally-cleared derivatives
Exchange-traded derivatives
Trade negotiation
Trades are bilaterally negotiated between the counterparties
Trades are bilaterally negotiated between the counterparties
Trades are executed on organized exchanges
Contract terms
Customized contract terms
Standardized contract terms
Standardized contract terms
Collateral requirements
  • Posting of collateral is not required unless each party agrees to it as a requirement for the trade. Collateral agreements are customized
  • Requirements for initial margin are set by the clearing house irrespective of the quality of the counterparty
  • Variation margin is subject to daily movement
  • Requirements for initial margin are set by the clearing house irrespective of the quality of the counterparty
  • Variation margin is subject to daily movement

1.3.1 Over-the-counter derivatives

OTC derivatives are traded and bilaterally negotiated directly between the counterparties, without going through an exchange or other intermediary. OTC derivatives are customized contracts that allow the counterparties to hedge their specific risks. Common OTC derivatives include swaps, forward rate agreements, and options.
The OTC derivative market is the largest market for derivatives. Because the OTC derivative market includes banks and other sophisticated entities, it is largely unregulated with respect to disclosure of information between the parties. Given the limited regulations, OTC derivatives generally present greater counterparty credit risk. To offset this risk, counterparties may negotiate collateral requirements (sometimes referred to as “margin”). When margin is provided, the derivative contract is considered collateralized; it is uncollateralized when there are no margin requirements.
An OTC derivative generally requires one contract (e.g., an ISDA agreement) between the two parties.
Figure DH 1-3 shows the direct relationship and flows of information and assets between counterparties to OTC derivatives.
Figure DH 1-3
Parties to an OTC derivative
Figure 1-2 Parties to an OTC derivative View image

1.3.2 Centrally-cleared derivatives

Centrally-cleared derivatives are negotiated between the counterparties but contain standardized terms and are traded through a central clearing house. The use of standardized terms facilitates the computation of required margin by the clearing house. Because the derivative counterparties are required to post collateral to satisfy the mandatory margin requirements, the counterparties are not subject to counterparty credit risk; instead, they are subject to the credit risk of the clearing house. Centrally-cleared derivatives offer certain advantages over OTC derivatives, including standardization, liquidity, and the elimination of counterparty credit risk.
Reforms mandated by the Dodd-Frank Act require certain types of derivatives (e.g., interest rate swaps, credit default swaps) to be processed through designated electronic trading platforms and cleared through registered clearing houses. As a result, derivatives have increasingly been executed through clearing houses rather than transacted bilaterally in an OTC market.
Centrally-cleared derivatives require multiple legal contracts between the various parties involved. The parties involved in a centrally-cleared derivative include:
  • End user – the reporting entity hedging its risk
  • Swap execution facility – the trading system used to provide pre-trade information (i.e., bid and offer prices) and the mechanism for executing swap transactions
  • Swap dealer – the market maker in swaps that regularly enters into swaps with counterparties
  • Clearing member – a member firm of a clearing house and a derivative exchange
Figure DH 1-4 shows the relationships and flows of information and assets between parties to a centrally-cleared derivative.
Figure DH 1-4
Parties in a centrally-cleared derivative

1.3.2.1 Collateralized-to-market / settled-to-market

Centrally-cleared derivatives can be structured and documented as “collateralized-to-market” or “settled-to-market.” The difference between these two types of derivatives is the mechanism used to limit or settle counterparty credit risk and the characterization of variation margin payments.
While the objective of the collateralized-to-market and settled-to-market provisions are similar, the nature of the rights and obligations between the counterparties are different. Centrally-cleared derivatives require the out-of-the-money counterparty to periodically transfer variation margin equal to the cumulative change in the fair value of the underlying asset of the derivative contract to the in-the-money counterparty. The cash flows exchanged by the counterparties in collateralized-to-market and settled-to-market derivatives are typically identical (and include both an initial and variation margin) but the characterization of the variation margin differs. For collateralized-to-market derivatives, the variation margin transferred is recorded as collateral with a receivable/ payable for the eventual return of the collateral. For settled-to-market derivatives, the variation margin transferred is recorded as a legal settlement of the derivative contract (the variation margin legally settles the outstanding exposure, but does not result in any other change or reset of the contractual terms of the derivative).
See DH 1.3.3.1 for additional information on margin.

1.3.3 Exchange-traded derivatives

Exchange-traded derivatives are traded on specialized derivative exchanges or other exchanges that act as the intermediary for the transactions. Similar to centrally-cleared derivatives, exchange-traded derivatives have standardized terms and margin requirements governed by the clearing house. Common exchange-traded derivatives include futures and options.

1.3.3.1 Margin

Clearing houses require margin to be posted to mitigate losses as a result of adverse price movements or default by a clearing member or end-user. Initial margin is the amount required to be posted (per trade) to begin transacting through the clearing house. It can consist of cash, securities, or other collateral. Variation margin is the amount required to be paid or received periodically as dictated by the clearing member and/or clearing house. In addition to the change in value of the derivative, a clearing house may decide to incorporate additional amounts to be posted to mitigate nonpayment or other risks. The periodic movements of variation margin are considered either (1) a payment of collateral or (2) a settlement of an open position, depending on the legal determination under the ISDA or other agreements. This is not an accounting election; it requires a legal assessment of the specific terms of each trade and the legal relationship with the clearing member and clearing house. The legal form of the variation margin, whether deemed to be collateral or a settlement payment, may have accounting and reporting implications.
1 exchange-traded derivatives
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