How to Understand Global Market Derivatives?

Derivatives are a vital class of financial instruments that are fundamental to today’s financial and trade markets. They provide different types of risk protection and facilitate pioneering investment strategies.

Around two decades ago, the derivatives sector was very small. Since then it has expanded remarkably, into a large and truly global market.

No other class of financial instruments has witnessed as much innovation. The combination of product & technology innovation with competition have sustained the remarkable growth that has generated several new jobs both at exchanges and intermediaries as well as at connected service providers.

Considering the derivatives market’s global character, investors could trade around the clock and use derivatives that provide exposure to virtually any "underlying" across all markets and asset classes. The derivatives market is mainly a specialized wholesale market with banks, investment firms, insurance companies, and corporates as its main participants.

There are two opposing segments in the derivatives market: the off-exchange or over-the-counter (OTC) segment and the on-exchange segment. From a customer perspective, on-exchange trading is less expensive than OTC trading.

Overall, the derivatives market is safe. Risks are managed in the exchange segment, where central counterparties (CCPs) function effectively and mitigate the risks for all market players.

In this regard, derivatives have to be differentiated from structured credit-linked security such as collateralized debt obligations.

The derivatives market has developed under an efficient regulatory regime. All three fundamentals for a well-functioning market - security, effectiveness, and innovation are fulfilled.

Though there is no need for structural transformations in the framework under which OTC players and exchanges function at present, developments are probable. Especially in the OTC segment, growing operating effectiveness, increasing market transparency and improving counterparty risk mitigation would assist the global derivatives market to operate even more effectively.

The derivatives market has attracted attention due to the financial crisis, fraud cases and the almost failure of the certain market participants.

Derivatives ensure future risks are tradable, which results in two key uses for them. The first is to remove uncertainty by exchanging market risks, also known as hedging. Corporates and financial institutions, use derivatives to safeguard themselves against changes in raw material prices, exchange rates, and interest rates.

The second use of derivatives is from an investment perspective. Derivatives are a substitute to investing directly in assets without purchasing and holding the asset itself. They enable investments into underlyings and risks that could not possibly be purchased directly.

Derivatives also enable investors to take positions against the market if they forecast the underlying asset to fall in value.

Normally, investors would enter into a derivatives contract to sell an asset (such as a single stock) if they believe it is overvalued, at a stated future point. This investment would be successful if the asset value falls. Such strategies are very critical for a proficiently functioning price discovery in financial markets as they decrease the risk of assets becoming excessively under- or overvalued.

Derivatives have not only expanded the investment environment; they have also substantially reduced the cost of investing.

The derivatives market has developed quickly in recent times as the benefits of using derivatives like effective risk mitigation and risk transfer have become very crucial.

Europe is the most vital region for derivatives that have become a key part of the European financial services sector and a main direct & indirect contributor to economic development.

The derivatives value chain could be classified as derivatives pre-trading, derivatives trading and clearing.

Broker-dealers (huge investment banks), exchanges and clearing houses are the key service providers along the value chain.

Pre-trading contains the initiation of derivatives orders to markets for the implementation of transactions.

Trading consists of matching the buyers and sellers in derivatives contracts. Implementation indicates that the buyer and the seller respectively enter into the derivatives contract.

Usually, dedicated derivatives dealers continuously provide price offers for contracts. This is known as market making and is considered a part of trading.

A derivatives trade develops an "open" derivatives contract. Derivatives clearing handles these "open" contracts until their completion, and is closely connected to derivatives trading as "open" contracts could be traded again and need to be managed throughout the contracts.

A vital element of derivatives clearing is position management. It deals with monitoring open derivatives contracts, including managing the risks present during the life of a contract.

Typically, derivatives contracts are not settled physically or do not even forecast physical settlement, as is the case for interest rate, credit default swaps, and most exotic derivatives.

Revenues from derivatives trading and clearing could be categorized along the value chain functions only for the exchange segment. As far as the OTC segment is concerned, broker-dealers are the key players and deliver service throughout the value chain in a combined manner.

The derivatives market is very competitive. Normally, there are two signs for competition in a market: new market players and customer choice. The derivatives market is impacted by both. New players regularly enter the market and customers can select between several substitute products across both its segments.

In order to deliver optimum benefits to the users and the economy, the derivatives market must meet requirements:

• Ensuring safety of the investment.
• Facilitating risk mitigation.
• Improving product innovation.

The derivatives market is very complex and quickly become a very vital segment of the financial market. Continuous product and technology innovation have fuelled growth.

A well-functioning derivatives market accomplishes its economic activities of price efficiency and risk distribution. An effective environment is required to improve security, transparency and operational effectiveness in the long-term.

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