OTC Derivatives: A Backstop Against Disorderly Markets
March 25, 2024
David Cohen
Head of Marex Hedging Solutions
In an earlier publication, I explained how the OTC derivative market was driven by innovation and extending the boundaries of standardised Exchanged-Traded Derivative (ETD) products.
ETD platforms perform their main duties – safety in execution and market integrity – even under challenging circumstances such as material changes in the macro-economic outlook, or geopolitical shocks. But from time to time, we experience black swan events, which usually manifests as a deviation in the index price and realised volatility. In these situations, the OTC markets can serve as an adequate supplemental tool to the ETD markets.
Think of it as a pressure release valve.
The remainder of this article discusses the main functions of ETD markets and the occasional challenges that arise in highly volatile environments. It will also describe how OTC derivative providers can help smooth market functioning during these situations.
Exchange-Traded Derivative Market Dynamics
ETDs provide market players with standardised contracts that are traded on formal exchanges. They are based on four pillars that guarantee their integrity as trading platforms: (a) comprehensive term product offering; (b) standardisation of instruments; (c) secured credit risk mechanism; and (d) third party risk mitigation via clearing houses.
(a) Futures and Options: Futures compel buyers and sellers to transact at a predetermined price on a future date, while options provide the right but not the obligation to do so. These instruments are pivotal for market participants, whatever their trading objectives – hedging and speculating.
(b) Standardisation: ETDs offer a uniform platform for trading with features like contract size, expiration dates, and settlement mechanism being standardised. This simplifies the process for participants and allows a maximum of them to recognise the utility of a given index and thus enhance liquidity (or volume and size of trading action).
(c) Initial Margin and Variation Margin: Traders are required to deposit an initial margin and may face variation margin calls if the market moves against their positions. This ensures the financial integrity of the market for each market participant at all times.
(d) Clearing Houses: As intermediaries, clearing houses mitigate risk by ensuring financial obligations are met, thereby promoting financial stability in the market. In effect, this is achieved by delegating traders’ asset and liability management to an external party.
In a normal market context, these four pillars ensure the proper functioning of the market, helping forward buyers to meet sellers in a secured and efficient way.
However, when markets get distorted, some challenges may arise.
Challenges with ETDs in Volatile Markets
Volatility can temporarily disrupt the functioning of ETDs. For example:
1/ Instruments: Challenge in Price Discovery and Market Efficiency. Excessive volatility can impact the efficacy of price discovery and hedging strategies. If market participants question the pricing of the instrument, they could disengage, complicating price discovery for the underlying asset.
2/ Standardisation: Challenge in Market Gaps and Limit Moves. ETD platforms have developed a mechanism to protect participants from abrupt price changes (aka “gapping”). However, this usually involves market closures, which may hinder price discovery.
3/ Margin calls: Challenge in working capital requirements. When volatility surges, so does the frequency and size of margin calls. This can lead to liquidity issues for market players who might not have sufficient funds to meet these demands. And in a nice Murphy law cycle, this usually coincides with increase in Initial margin factors, even as intraday calls for payment.
At the minimum, this will put pressure on market participants’ working capital and the whole Margin financing ecosystem supporting such a market. In the worst case, it could create liquidity gaps as market players leave the market having no choice but cutting their positions.
In some volatile situations, private counterparties can play an important role in relieving some of the pressure on ETD platforms and improve market functioning.
This is precisely what Over-The-Counter (OTC) market providers can do.
The OTC Derivative Advantage in Volatile Markets
We described in an earlier article how OTC derivatives could offer a flexible complement to ETDs. Now let’s look at their role in the context of high volatility:
1/ Instruments: Bespoke Solutions. OTC markets enable the creation of bespoke products designed specifically to address the intricacies of highly volatile scenarios – early expiry options, broken lot volumes, specific settlement terms. These are specificities that an OTC provider can price and trade on demand should there be a need for it.
2/ Standardisation: “Who can do more, can do less”. OTC providers, at the minimum, can replicate the standardised trading instruments. This would allow an easy transfer into an ETD platform should markets return to better efficiency.
3/ Margin calls: Working Capital Relief. Through reduced margin requirements compared to ETDs, OTC derivatives provide crucial working capital relief to market participants. Usually resulting from a thorough credit analysis of their counterparties, OTC providers can provide a framework free of initial margin requirement – the factor that usually soars in a highly volatile context onto ETDs platforms – as well as variation margin to some extent.
4/ Counterparty Risk Management. Clearing houses will always perform on their duties – mitigating counterparty risk between market players – however, since an OTC bilateral transaction is executed between two private parties, it is critical for both parties to analyse the credit worthiness of its counterparty. Choosing an Investment Grade rated entity, specifically in a volatile context, is an additional layer of safety in the process of pivoting to an OTC provider during stress market episodes.
In conclusion, while ETDs offer a structured and regulated environment, they can face some challenges under extreme volatility. OTC derivatives, with their adaptability and customised solutions, provide relief and flexibility, improving price discovery and enabling market participants to navigate tumultuous periods more effectively.
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