Derivative contracts are financial instruments that grant rights to some future payment or other consideration that is defined with reference to the value or amount of some underlying asset, rate or index.
Derivatives allow banks and other financial and non-financial institutions to mitigate risk and generate tailored exposures to variables, such as interest rates, or events, such as the credit default of a corporation.
While derivatives are a valuable tool in managing or hedging against risk, they are also a source of counterparty credit risk. Derivative contracts bind counterparties together for the duration of the contract. Throughout the lifetime of a contract, counterparties build up claims against each other, as the rights and obligations contained in the contract evolve as a function of changing circumstances.
The management of derivatives contracts may also be a source of operational risk.
Importantly, derivatives may also be a channel for financial contagion between market participants.
While many derivatives are traded on exchanges, such as the ASX 24 market, others are negotiated bilaterally ‘over-the-counter’ (OTC) between the buyer and the seller.
OTC derivatives often incorporate bespoke terms to allow the contracting parties to manage specific risks. This is in contrast to exchange traded derivatives that are typically highly standardised. OTC derivatives markets have traditionally been subject to less direct regulation than exchange-based markets.
The global OTC derivatives market is of a significant size – the total notional amount outstanding for OTC derivatives worldwide was $639 trillion at end of June 2012.1 The Australian market is small by comparison, comprising less than 5 per cent of the global market. But as is the case in most countries, Australian-located OTC derivatives market participants are extensively involved in overseas markets.
The technology supporting financial markets and the nature of derivatives means that a participant located in Australia can very easily transact with a participant located offshore. The ability of locally-based market participants to participate in global markets reduces transaction costs and increases the range of available counterparties and products, in turn enhancing the depth and breadth of the Australian market. Australian banks are also active in foreign marketplaces through their overseas branches.
However the financial crisis in 2008 highlighted structural deficiencies in the global OTC derivatives market and the systemic risks that those deficiencies can pose for wider financial markets and the real economy.
In many countries, these structural deficiencies contributed to the build-up of large, insufficiently risk-managed, counterparty exposures between some market participants in advance of the global financial crisis; and to the lack of transparency about those exposures for market participants and regulators.
The deficiencies may also contribute to market inefficiency, uncertainty, loss of confidence and loss of market liquidity, particularly when the market comes under stress.
The G-20 commitments aim to bring transparency to OTC derivative markets and improve risk management practices. Reducing risk and increasing transparency brings significant benefits to the economy as a whole by making derivatives markets more stable and efficient, especially in times of crisis.
Fulfilling Australia’s obligations in a globally coordinated way will also help to ensure that global markets remain open to Australian business. Companies wishing to purchase or sell a derivative contract will benefit from reduced market impact costs to trading2 and extra liquidity, which allows them to trade when they wish to trade. This benefits the economy as a whole.
Participating in global derivatives markets also allows companies to better tailor their derivatives to their risks. This is of value to Australian companies and the economy as a whole.
Global implementation of the G-20 commitments also ensures that Australian businesses, investors and corporations have the benefit of improved risk management practices and transparency when they participate in international markets.
- Statistical release: OTC derivatives statistics at end-June 2012, November 2012, Bank for International Settlements, http://www.bis.org/publ/otc_hy1211.pdf
- Market impact is the adverse price movement that can occur when a trade is executed; larger, more liquid markets have lower market impact costs.