Managing Derivatives Contracts: A Guide to Derivatives Market Structure, Contract Life Cycle, Operations, and Systems

476 Pages·2014·6.86 MB·English

by  Khader Shaik (auth.)

®
BOOKS FOR PROFESSIONALS BY PROFESSIONALS
Managing Derivatives Contracts
Managing Derivatives Contracts is a comprehensive and practical treatment of the end-to-end man-
agement of the derivatives contract operations, systems, and platforms that support the trading
and business of derivative products. This book focuses on the processes and systems in the
derivatives contract life cycle that underlie and implement the activities of derivatives trading, pric-
ing, and risk management.
Khader Shaik, a Wall Street derivatives platform implementation expert, lays out all the funda-
mentals needed to understand, conduct, and manage derivatives operations. In particular, he pro-
vides both introductory and in-depth treatment of the following topics: derivative product classes;
the market structure, mechanics, and players of derivatives markets; types of derivative contracts
and life cycle management; derivatives technology platforms, software systems, and protocols;
derivatives contracts management; and the new regulatory landscape as shaped by reforms such
as Dodd-Frank Title VII and EMIR. Managing Derivatives Contracts focuses on the operational pro-
cesses and market environment of the derivatives life cycle; it does not address the mathematics
or finance of derivatives trading, which are abundantly treated in the standard literature.
Managing Derivatives Contracts is divided into four parts. The first part provides a structural
overview of the derivatives markets and product classes. The second part examines the roles
of derivatives market players, the organization of buy-side and sell-side firms, critical data
elements, and the Dodd-Frank reforms. Within the framework of total market flow and straight-
through processing as constrained by regulatory compliance, the core of the book details the
contract life cycle from origination to expiration for each of the major derivatives product class-
es, including listed futures and options, cleared and bilateral OTC swaps, and credit derivatives.
The final part of the book explores the underlying information technology platform, software
systems, and protocols that drive the end-to-end business of derivatives. In particular, it sup-
plies actionable guidelines on how to build a platform using vendor products, in-house develop-
ment, or a hybrid approach.
This book teaches readers at all levels about such areas of the derivatives business as the
following: various execution models in the derivatives market; STP contract workflow within the
firm and across external entities; market structure involving dealers, inter-dealer brokers, buy-side
firms, servicing firms, regulatory bodies, and other third-party administrators; notable species of
exotic derivatives as well as all the major derivatives product classes; implementation and inte-
gration of vendor and in-house platforms; FpML, FIX, and SWIFT protocols and standards; and
operational aspects of post-reform regulatory compliance.
ISBN 978-1-4302-6274-9
US $79.99 57999
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User level:
Intermediate–Advanced 9 781430 262749
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Shaik
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Contents
foreword ix
About the Author xi
About the technical reviewer xiii
Acknowledgments xv
preface xvii
part i: the Big picture 1
chapter 1: the derivatives Market 3
chapter 2: the derivative products 21
chapter 3: derivatives and risk Management 59
chapter 4: the derivatives contract 83
part ii: Market structure 103
chapter 5: the Market players 105
chapter 6: the Buy-side organization 145
chapter 7: the sell-side organization 159
chapter 8: Market and reference data 171
chapter 9: the dodd-frank Act and other reforms 185
part iii: contract Life cycle 211
chapter 10: the derivatives contract Life cycle 213
chapter 11: collateral Management 251
chapter 12: futures Life cycle 275
chapter 13: Listed options Life cycle 295
chapter 14: otc cleared contract Life cycle 311
chapter 15: otc Bilateral contract Life cycle 321
chapter 16: credit contract Life cycle 339
viii Contents
part iv: systems 353
chapter 17: derivatives and information technology 355
chapter 18: it platforms and systems 369
chapter 19: platform Architecture and implementation Guidelines 401
index 457
P A R T
I
The Big Picture
C H A P T E R
1
The Derivatives
Market
Derivatives play a vital role in today’s global economy. They are powerful and
versatile tools. Derivatives enable financial institutions, large corporations, and
high-net-worth individuals to manage their exposure to financial risk in its
manifold forms. The global derivatives market operates seamlessly around the
clock, trading a constantly mutating variety of complex instruments on rapidly
changing technology platforms.
The pace and direction of these changes have been hastened and shaped by the
financial crisis of 2008 and its recessionary aftermath. These events exposed
systemic shortcomings and catastrophic perils in the derivatives market and
antagonized public perception of it. The phasing in of root-and-branch regula-
tory reform of the derivatives market has prompted transformative adapta-
tions in derivative instruments, technology platforms, and the management
and operation of the whole derivatives contract life cycle.
Unlike most books on derivatives, which deal with the mathematical t echniques
and models of risk management, this book focuses on what nonquantitative
derivatives professionals need to know about the end-to-end derivatives life
cycle. It shows such professionals, who outnumber the cadre of quants by
an order of magnitude in the typical derivatives organization, how to adjust
s uccessfully to the new and emerging product, technology, and regulatory
conditions of the post-2008 derivatives market.
The objectives of this foundation chapter are briefly to
• define the financial derivative
• outline the structure and size of the derivatives market
and its submarkets
4 Chapter 1 | The Derivatives Market
• set out the need for derivatives and their benefits to the
economy and capital markets
• explore the systemic dangers and risks of derivatives
• survey the ongoing regulatory changes in the derivatives
market
• identify the operational and technical challenges of man-
aging derivative contracts in the emerging new regulatory
landscape
• discuss the importance of information technology in each
area of derivatives contract management
Financial Derivatives
A derivative is an instrument derived from at least one other elementary instru-
ment known as the underlying; the value of a derivative instrument depends
on the value of the underlying. Examples of underlyings include stocks, bonds,
exchange rates, interest rates, credit characteristics, indices, commodities, and
other derivative instruments.
From a practical standpoint, the derivatives contract is simply an agreement
between two parties, and its performance is derived from the underlying—
hence the name derivative. An example of a derivative is an option contract on a
stock issued by some corporation, in which the value of the option is derived
from the performance of the stock. Another example of a derivative is an
interest rate swap, whose value is derived from the underlying interest rate
index on which it is based.
Derivatives can be divided into two major categories: financial derivatives and
commodity derivatives. Financial derivatives are derived from financial instru-
ments such as stocks, bonds, interest rates, and currency rates. Commodity
derivatives, on the other hand, are derived from underlying commodities such
as precious metals, agricultural products, and commodity indices. This book is
concerned only with financial derivatives. The term derivatives and its various
synonyms—financial derivative instruments, derivative contracts, c ontracts, derivative
products, and derivative instruments—should be understood t hroughout this
book to refer to financial derivatives.
Derivative instruments are distinguished from other financial instruments by
the following characteristics:
Life span. Unlike a securities transaction (stock or bond) that is
settled at once, a derivatives contract starts on a certain date and
stays in effect until some later date with one or multiple settlements
during that period. The life span of a derivatives contract may vary
from a few weeks to many years.
Managing Derivatives Contracts 5
Settlement. Derivative contracts are settled either financially
(cash-settled) or through physical delivery (delivery-settled). Most
derivative contracts are cash-settled regardless of the underlying.
This enables participants to trade various types of derivatives
without owning the underlying assets. However, a small proportion
of derivative contracts are physically settled by delivering the actual
underlying assets. Contract terms specify method of settlement and
eligible assets that can be delivered in case of physical delivery.
Investment. Derivatives—even those with large notional value
(the nominal or face amount of contract)—typically require only
a nominal investment such as an initial margin, whereas securities
(such as stocks, loans, and bonds) transactions require upfront
investment.
Positions. Technically, market participants do not buy or sell
derivatives in the same way that they transact other financial
instruments. Rather, they enter into (open) and terminate (close)
derivatives positions. During the contract term, most derivative
contracts are valued using market prices; others are valued using
mathematical models. Derivative contracts are often managed on a
portfolio basis, combined with other assets or derivatives.
Credit risk. The credit risk involved in derivative transactions is
different from the credit risk carried by other financial instruments.
For example, with a loan, the amount at risk is the principal paid
to the borrower. The credit risk is unilateral, meaning that only the
lender is exposed to risk from the borrower. In contrast, the credit
exposure in most derivative transactions is bilateral. Because the
value of a derivative may swing to either side, each party involved may
be exposed to risk at various points over the life of the contract.
Cash-flow direction. During the term of most derivative contracts,
two-way cash flows are common. Most other financial instruments
have only one-way cash flows.
Risk exposure. Derivatives enable participants to trade risk
exposure from an underlying asset without actually owning that
asset.
Position management. The risk of holding a derivatives contract
may be dissimilar to the risk of holding its underlying. For instance,
the risk involved in purchasing a bond is not necessarily the same as
the risk involved in purchasing a derivatives contract on that same
bond. As a result, managing derivative positions is quite different
from managing the position in the underlying.
6 Chapter 1 | The Derivatives Market
The Derivatives Market Structure
The derivatives market is broadly divided into two submarkets: the listed
market and the over-the-counter (OTC) market. These submarkets are differen-
tiated by their products and their regulatory and operational requirements, as
depicted schematically in Figure 1-1 and described in the following sections.
Derivatives Market
Listed Market OTC Market
Standard
Contracts
Cleared Market Bilateral Market
Exchanges
Cleared Custom
Contracts Contracts
Clearinghouses
Electronic Traditional,
Platforms (SEFs) Electronic
Platforms
Clearinghouses Bilateral
Clearing
Figure 1-1. Derivatives market segments
The Listed Market
The listed market consists of standardized contracts traded on exchanges.
A derivatives exchange is a regulated entity that provides a trading facility to
its members. The derivative products on the exchange are standardized with
specific delivery and settlement terms. Today’s derivatives exchanges trade
a wide variety of contracts, ranging from simple stock options to interest
rate swaps. As financial instruments evolve, exchanges continue to introduce
v ariety of products.
The listed market is also called the exchange market, the regulated market, or
the organized market. The products traded on the listed market are variously
called listed derivatives, listed contracts, on-exchange derivatives, or standardized
derivatives.
Managing Derivatives Contracts 7
Traditionally, trading on exchanges took place on a physical trading floor
through a face-to-face auction process. Today, most derivatives exchanges have
replaced or supplemented their floor-based trading with electronic trading.
Trading on exchanges is limited to standard contracts. All listed products
are cleared by a designated clearinghouse, which guarantees the fulfillment of
contractual obligations. Central clearing virtually removes the credit risk from
listed contracts. Since these contracts traded on exchanges, they provide
higher liquidity.
The major benefits of listed markets are the following:
• The obligations of listed contracts are guaranteed by
the clearinghouse. As the central counterparty (CCP) to a
listed contract, the clearinghouse eliminates counterparty
credit risk.
• All contracts are highly standardized in nature. For
instance, the expiration date, underlying entity, settle-
ment style, and all other key attributes of contracts are
predefined by the exchange. Hence, the exchange market
is efficient and provides multilateral trading and substan-
tial liquidity.
• Exchange trading leads to lower transaction costs.
• Clearinghouse and clearing members use a margining
process to manage the risk. All positions are marked-to-
market on a daily basis (sometimes even more than once
a day). This virtually eliminates counterparty risk.
• Exchange-traded derivatives have greater price transpar-
ency because all trading prices are publicly available.
Despite the many benefits of the listed market, listed contracts are still not
sufficient to serve the fundamental needs of those trading derivatives. Listed
contracts may not serve all the risk management needs of a portfolio in terms
of duration and quantity. In addition, in certain situations, it may be more
expensive to hedge the risks that exist in a portfolio using listed contracts.
The next section explains how the OTC market fulfills certain needs that are
not adequately met in the listed market.
The Over-the-Counter Market
Over-the-counter (OTC) is a term used to describe trading activity that does not
take place on a regulated exchange. In the OTC market, contracts are negoti-
ated (traded) in different ways. The OTC market divides into two parts: the
bilateral OTC market and the cleared OTC market.