What are Exchange-Traded Derivatives?
Exchange-traded derivatives consist mostly of options and futures traded on public exchanges, with a standardized contract. Through the contracts, the exchange determines an expiration date, settlement process, and lot size, and specifically states the underlying instruments on which the derivatives can be created.
Hence, exchange-traded derivatives promote transparency and liquidity by providing market-based pricing information. In contrast, over-the-counter derivatives are traded privately and are tailored to meet the needs of each party, making them less transparent.
- Exchange-traded derivatives are futures and options with a standardized contract, traded on public exchanges.
- Common ETDs include stock, index, currency, commodities, and real estate derivatives.
- Standardized contracts increase liquidity and market depth. On the other hand, it reduces flexibility and eliminates the benefits of negotiation.
Types of Exchange-Traded Derivatives
1. Stock derivatives
Common stock is the most commonly traded asset class used in exchange-traded derivatives. Global stock derivatives are seen to be a leading indicator of future trends of common stock values.
2. Index derivatives
Index-related derivatives are sold to investors that would like to buy or sell an entire exchange instead of simply futures of a particular stock. Physical delivery of the index is impossible because there is no such thing as one unit of the S&P or TSX.
3. Currency derivatives
Exchange-traded derivatives markets list a few currency pairs for trading. Futures contracts or options are available for the pairs, and investors can choose to go long or short.
4. Commodities derivatives
The commodity market relates to the raw materials sector. Derivatives trading in commodities includes futures and options that are secured by physical assets or commodities.
5. Real estate derivatives
Real estate derivatives allow people to invest in real estate without ever owning physical buildings. They are widely traded and were at the heart of the 2008 Global Financial Crisis.
Clearing and Settlement of Exchange-Traded Derivatives
Exchange-traded derivatives require an initial deposit settled through a clearinghouse. Clearinghouses will handle the technical clearing and settlement tasks required to execute trades. Most are also traded with a central clearing counterparty (CPP), which are highly regulated institutions that manage credit risk between two trading parties.
Benefits of Exchange-Traded Derivatives
1. Highly liquid
Exchange-traded derivatives have standardized contracts with a transparent price, which enables them to be bought and sold easily. Investors can take advantage of the liquidity by offsetting their contracts when needed. They can do so by selling the current position out in the market or buying another position in the opposite direction.
The offsetting transactions can be performed in a matter of seconds without needing any negotiations, making exchange-traded derivatives instruments significantly more liquid.
High liquidity also makes it easier for investors to find other parties to sell to or make bets against. Since more investors are active at the same time, transactions can be completed in a way that minimizes value loss.
2. Intermediation reduces the risk of default
Exchange-traded derivatives are also beneficial because they prevent both transacting parties from dealing with each other through intermediation. Both parties in a transaction will report to the exchange; therefore, neither party faces a counterparty risk.
The intermediate party, the exchange, is believed to be a credible party by most traders around the world. The exchange will act as an intermediary and assume the financial risk of their clients. By doing so, it effectively reduces default and credit risk for transacting parties.
3. Regulated exchange platform
The exchange is considered to be safer because it is subject to a lot of regulation. The exchange also publishes information about all major trades in a day. Therefore, it does a good job of preventing the few big participants from taking advantage of the market in their favor.
Disadvantage of Exchange-Traded Derivatives
Loss of flexibility
The standardized contracts of exchange-traded derivatives cannot be tailored and therefore make the market less flexible. There is no negotiation involved, and much of the instruments’ properties have been already outlined in the contracts.
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