- Burkhard Drees, Garry Schinasi, Charles Kramer, and R. Craig
- Published Date:
- January 2001
While derivatives or derivative-like features can be found in the earliest recorded financial contracts, until quite recently derivatives markets, to the extent they existed, were probably relatively illiquid. This Appendix chronicles the development of the preconditions necessary to support the high degree of liquidity that characterizes modern OTC derivatives markets. These include the rise of financial institutions capable of functioning as market makers, the establishment of derivatives exchanges that provide hedging vehicles and enable market makers to manage their risk, and advances in information technology and finance theory that facilitate more accurate pricing of OTC derivatives and measurement of risk. Derivatives or financial contracts with derivative-like features seem to have existed throughout recorded financial history. Such contracts specify rights or obligations to make or receive transfers depending on the value, or on outcomes affecting the value, of an underlying financial instrument or commodity. They encompass both separate derivatives contracts that can be traded on a market and financial contracts with embedded options or contingent clauses. Derivatives traded on markets differ from other marketable instruments in that their value “derives” entirely from that of an underlying financial instrument or commodity.
Derivative-like features can be found in very early financial contracts. The first recorded example dates back to the time of Hammurabi (1800 BC), ruler of ancient Babylon, and is included in Hammurabi’s code, the first formal recorded legal code. The code, which among other things regulated terms of credit, specified that in the event of a crop failure due to storm or drought, interest on that year’s land loan would be canceled.109 This example of a derivative, broadly defined, takes the form of a contingent clause embedded in and modifying a financial contract (the land loan) so as to give it derivative-like characteristics. The clause provides partial insurance against natural disasters by canceling interest payments when they occur.
Financial contracts with embedded options were likely the primary form of derivatives for much of recorded financial history. As financial markets developed, they seem to have evolved into forms resembling existing securities with embedded options. For example, beginning in sixteenth century Europe, convertible securities and preferred stock—instruments with derivative-like properties—appear to have been increasingly used.110 The main drawback of embedded options was that they could not be traded separately from the underlying instrument.
A key innovation was the creation of derivative instruments that could be traded separately from the underlying financial instrument or commodity. The earliest recorded such instruments appear to have been Venetian government bond forwards in thirteenth century Venice.111 In this early period, the exchange of financial instruments, and derivatives based on these instruments, seems to have initially taken place on an informal and bilateral basis in locations such as coffeehouses. In the sixteenth century, as financial activity increased in cities like Amsterdam and London, these bilateral contacts evolved into meetings of groups of investors, effectively establishing informal markets for the trading of financial instruments including derivatives. These markets could be regarded as early OTC markets in that they were based on networks of bilateral linkages, although they lacked key institutional features, such as market makers, that are the source of liquidity in modern OTC derivatives markets.
This market activity evidently provided the basis for the creation of exchanges in the emerging financial centers. These early “traditional” exchanges differed significantly from modern exchanges. Rules governing trading were much less restrictive and standardization of contracts was limited. Typically, a wide range of different financial instruments was traded on relatively illiquid markets. The modern distinction between exchange and over-the-counter trading was probably of limited relevance since trading tended to occur on a bilateral basis.
The first organized exchange was founded in Amsterdam in 1610.112 A wide range of contracts were traded on it, including stocks, commodities, insurance, a form of money market instrument, futures, and stock options. Also, there was a system of margin lending that could be used as a source of leverage.113 In London, an exchange existed by the end of the seventeenth century, although trading activity seemed to have remained somewhat more decentralized with substantial amounts of trading continuing to occur in other locations such as coffeehouses. For example, trading in equities apparently only became centralized on a single exchange in 1802. Derivatives trading was sharply curtailed in England following the collapse of the South Sea Bubble in the fall of 1720 as the result of legislation banning short sales, which was not repealed until 1836. In the United States, in the late eighteenth and early nineteenth century, the development of securities trading, including derivatives trading, followed the pattern of Amsterdam and London with the founding of the New York Stock Exchange in 1817.
Early derivatives seem to have predominantly been forwards, probably because they were relatively straightforward to value. Equity options were also traded. For example, trading in equity derivatives appears to have become well established in London by the late seventeenth century. Records indicate that these derivatives were used for risk management and speculation. They also show that investors were using relatively sophisticated finance concepts such as present value and discounted cash flow analysis to price them.114 For example, in 1692, John Houghton, owner of a London coffee shop where equity trading took place, published an explanation of how a put option could be used to hedge against a fall in the price of an equity. During the South Sea Bubble, compensation of South Sea Company management (and bribery of officials) consisted in part of stock options.
While these early derivatives markets resembled modern OTC derivatives markets in that trading occurred through a network of bilateral contacts, they lacked the liquidity of modern OTC derivatives markets, because markets lacked institutions that could act as market makers and provide liquidity by temporarily taking over and holding a seller’s derivative positions until a buyer could be located. Market making institutions only developed recently as financial instruments became available to enable them to hedge and manage the risk associated with this activity and when it became possible to accurately price derivatives and measure their risk. Also, since market making can involve carrying sizable positions, a financial infrastructure to provide the necessary financing needs to be in place. Only with the creation of liquid financial derivatives exchanges did adequate hedging instruments become available. The features of these exchanges were largely derived from modern commodity derivatives exchanges.
The first commodity futures exchange was the Osaka Rice Exchange in eighteenth century Japan. Commodity derivatives exchanges developed in roughly their current form in Chicago in the 1850s. Commodity derivatives exchanges were created to enable agricultural producers and wholesalers to hedge commodity price risk. They differed from the traditional financial exchanges, described above, in that only a limited number of standardized contracts were traded and the terms of contracts and exchange are specified by a relatively detailed set of rules. These features contributed to a high degree of market liquidity, enabling these markets to perform their price discovery function. In time, a regulatory structure developed to strengthen investor protection.
The trading of financial derivatives on modern exchanges—modeled on the commodity derivatives exchange—did not occur until quite recently. The first financial futures exchange was created in Chicago in 1970. In 1973, the first options exchange—trading call options on U.S. equities-opened, also in Chicago and, in 1977, the trading of put options was added. Subsequently, derivatives exchanges opened elsewhere in the United States and other countries such that, by the 1980s, options and futures on hundreds of equities and a wide range of bond. Treasury bill, and foreign exchange contracts were traded. The relatively recent extension of the commodity exchange model to financial derivatives can be partly attributed to several factors: the large number of underlying financial instruments, especially in the case of equities, limited the scope for standardization, making it more difficult to achieve sufficient liquidity; settlement on commodity exchanges was typically in the commodity rather than cash; and commodity exchanges were often located near commodity-producing regions far from the major financial centers where the underlying financial instruments were traded.115
The creation of liquid derivatives exchanges in combination with advances in finance theory and information technology provided the preconditions for the development of liquid OTC derivatives based on market makers by allowing them to effectively manage the risk associated with market making in OTC derivatives markets. Advances in finance theory, notably the Black-Scholes options pricing model, made it possible for the first time to accurately price many types of derivatives. They also facilitated dynamic hedging of derivatives exposures in the markets for the underlying instruments, which was useful in cases where exchange-traded derivatives were not available for hedging. The financial institutions that had been involved in derivatives activity prior to the establishment of these preconditions, either on a bilateral basis or on relatively illiquid traditional exchanges, were well positioned to function as market makers. The fact that in many cases they were large, internationally active financial institutions meant that they typically had access to the financing necessary to perform this function.
The early development of liquid OTC derivative markets was driven partly by incentives for regulatory arbitrage. These arose largely from the need to avoid capital and exchange controls that were essential elements of the post-World War II global financial system. Also, the introduction of capital requirements for banks gave rise to incentives to use OTC derivatives to circumvent or reduce them (by moving exposures off balance sheet). While regulatory arbitrage was important to the creation of these markets, market activity was increasingly driven by hedging and speculation as liquidity improved and the cost of participation fell.
The development of the foreign exchange swap market illustrates the role of regulatory arbitrage in the development of OTC derivatives markets. The first swaps were created in the 1960s to allow U.S. and U.K. multinationals who wanted to borrow in the others’ currency to circumvent U.K. exchange controls. Each firm would borrow in its own currency and then swap the principal so that no cross-border transactions were recorded (see Box 3.2: Motives for OTC Derivatives Transactions). The role of financial intermediaries was initially limited to matching counterparties (for example, they functioned as a broker). As swaps became more widely used, intermediaries took on the role of counterparty to each participant, effectively functioning as a market maker. In this capacity, they would carry the foreign currency position of a counterparty until they could find a buyer, who might be another financial intermediary. Their ability to hedge and finance such positions made it possible for them to perform this role.116
The development of an extensive and sophisticated OTC market infrastructure in the 1980s and 1990s with many of the world’s largest financial institutions serving as market makers has greatly enhanced the liquidity of OTC derivatives markets. This, in turn, has lowered the cost of participation and supported the expansion of the market. Measured by notional principal, OTC derivatives markets have grown to roughly nine limes the size of those for exchange-traded derivatives and have approximately the same turnover (see Figure 3.1).
The expansion of OTC derivatives markets will likely continue to be driven by technology and enhancements to the institutional infrastructure. The large volume of trading in some products on OTC derivatives markets has led to an increasing degree of standardization (for example, “plain vanilla” derivatives). The development of electronic trading, and clearing and settlement technologies, is making it possible to increase efficiency by introducing exchange-like trading arrangements for these products. As a result, the distinction between exchange-traded and OTC derivatives may become blurred and OTC products may increasingly compete with and displace comparable products on derivative exchanges.
The value of an asset that appears on a balance sheet based on historic cost or the original purchase price.
An intermediary between buyers and sellers who acts in a transaction as an agent, rather than a principal, charges a commission or fee, and—unlike a dealer—does not buy or sell for its own account or make markets. In some jurisdictions, the term “broker” also refers to the specific legal or regulatory status of institutions performing this function.
Provision (for example, in a master agreement) that stipulates the jurisdiction whose law governs an OTC derivatives transaction. The term sometimes is used to refer to the principles by which jurisdiction is determined in a dispute (also known as “conflict of law”).
The process of matching parties in a transaction according to the terms of a contract, and the fulfillment of obligations (for example, through the exchange of securities or funds).
An entity, typically affiliated with a futures or options exchange, that clears trades through delivery of the commodity or purchase of offsetting futures positions and serves as a central counterparty. It may also hold performance bonds posted by dealers to assure fulfillment of futures and options obligations.
Steps taken by a nondefaulting party to terminate a contract prior to its maturity when the other party fails to perform according to the contract’s terms.
Assets pledged as security to ensure payment or performance of an obligation.
The present value of the amount receivable or payable on a contract, consisting of the sum of current exposure and potential future exposure.
The exclusion of certain creditors from the automatic stay provision of the bankruptcy code, which generally limits creditors’ capacity to directly collect debts owed by a bankrupt party, including through netting of outstanding contracts. An example is the U.S. Bankruptcy Code statutory exceptions for repurchase agreements, securities contracts, commodity contracts, swap agreements, and forward contracts, where counterparties can close out exempt OTC derivatives positions outside of bankruptcy procedures.
The risk associated with the possibility that a borrower will be unwilling or unable to fulfill its contractual obligations, thereby causing the holder of the claim to suffer a loss.
An intermediary that acts as a principal in a transaction, buys (or sells) on its own account, and thus takes positions and risks. It earns profit from bid-ask spreads (and potentially from its positions). A dealer can be distinguished from a broker, who acts only as an agent for customers and charges commission. In some jurisdictions, the term “dealer” also refers to the specific legal or regulatory status of institutions performing this function.
Financial contracts whose value derives from underlying securities prices, interest rates, foreign exchange rates, market indexes, or commodity prices. Exchange-traded derivatives are standardized products traded on the floor of an organized exchange and usually require a good faith deposit, or margin, when buying or selling a contract. Over-the-counter derivatives, such as currency swaps and interest rate swaps, are privately negotiated bilateral agreements transacted off organized exchanges.
Defined by the Financial Accounting Standards Board as “the amount at which the instrument could be exchanged in a current transaction between willing participants, other than in a forced or liquidation sale.”
A contractual obligation between two parties to exchange a particular good or instrument at a set price on a future date. The buyer of the forward agrees to pay the price and take delivery of the good or instrument and is said to be “long the forward,” while the seller of the forward agrees to deliver the good or instrument at the agreed price on the agreed date, and is said to be “short the forward.” Collateral may be deposited up front, but cash is not exchanged for the good or instrument until the delivery date. Forward contracts, unlike futures, are not traded on organized exchanges.
A negotiable contract to make or take delivery of a standardized amount of a commodity or securities at a specific date for an agreed price, under terms and conditions established by a regulated futures exchange where trading takes place. It is essentially a standardized forward contract that is traded on an organized exchange and subject to the requirements defined by the exchange.
The difference between the amount advanced by a lender and the market value of collateral securing the loan. For example, if a lender makes a loan equal to 90 percent of the value of marketable securities that are provided as collateral, the difference (10 percent) is the haircut. The term also refers to formulas used in the valuation of securities for computing net capital positions of broker-dealers.
The process of offsetting an existing risk exposure by taking an opposite position in the same or a similar risk, for example, by purchasing derivatives contracts.
The process of transferring funds from an ultimate source to the ultimate user. A financial institution, such as a bank, intermediates credit when it obtains money from a depositor and relends it to a borrowing customer.
Risk that arises when a counterparty lacks the legal or regulatory authority to engage in a transaction or when the law does not perform as expected. Legal risks also include compliance and regulatory risks, which concern activities that might breach government regulations, such as market manipulation, insider trading, and suitability restrictions.
The magnification of the rate of return (positive and negative) on a position or investment beyond the rate obtained by direct investment of own funds in the cash market. It is often measured as the ratio of on- and tiff-balance-sheet exposures to capital. Leverage can be built up by borrowing (on-balance-sheet leverage, commonly measured by debt-to-equity ratios) or through the use of off-balance-sheet transactions.
The ability to raise cash easily and with minimal delay. Market liquidity is the ability to transact business in necessary volumes without unduly moving market prices. Funding liquidity is the ability of an entity to fund its positions and meet, when due, the cash and collateral demands of counterparties, credit providers, and investors.
The amount of cash or eligible collateral an investor must deposit with a counterparty or intermediary when conducting a transaction. For example, when buying or selling a futures contract, initial margin must be deposited with a broker or clearinghouse. If the futures price moves adversely, the investor might receive a margin call—that is, a demand for additional funds or collateral (variation margin) to offset position losses in the margin account.
The valuation of a position or portfolio by reference to the most recent price at which a financial instrument can be bought or sold in normal volumes. The mark-to-market value might equal the current market value-—as opposed to historic accounting or book value—or the present value of expected future cash flows.
An intermediary that holds an inventory of financial instruments (or risk positions) and stands ready to execute buy and sell orders on behalf of customers at posted prices or on its own account. The market maker assumes risk by taking possession of the asset or position. In organized exchanges, market makers are licensed by a regulating body or by the exchange itself.
The risk that arises from possible changes in the prices of financial assets and liabilities; it is typically measured by price volatility.
Comprehensive documentation of standard contractual terms and conditions that covers a range of OTC derivatives transactions between two counterparties.
Actions of economic agents that are to their own benefits but to the detriment of others and arise when incomplete information or incomplete contracts prevent the full assignment of damages (and/or benefits) to the agent responsible. For example, under asymmetric information, borrowers may have incentives to engage in riskier activities that may be to their advantage, hut which harm the lender by increasing the risk of default.
A written contract to combine offsetting obligations between two or more parties to reduce them to a single net payment or receipt for each party. For example, two banks owing each other $10 million and $12 million, respectively, might agree to value their mutual obligation at $2 million (the net difference between $10 million and $12 million) for accounting purposes. Netting can be done bilaterally—when two parties settle contracts at net value—as is standard practice under a master agreement, or multilaterally through a clearinghouse. Closeout netting combines offsetting credit exposures between two parties when a contract is terminated.
The reference value (which is typically not exchanged) on which the cash flows of a derivatives contract are based. For example, the notional principal underlying a swap transaction is used to compute swap payments in an interest rate swap or currency swap.
Financial commitments that do not involve booking assets or liabilities, and thus do not appear on the balance sheet.
Risk of losses resulting from management failure, faulty internal controls, fraud, or human error. It includes execution risk, which encompasses situations where trades fail to be executed, or more generally, any problem in back-office operations.
A contract granting the right, and not the obligation, to purchase or sell an asset during a specified period at an agreed-upon price (the exercise price or strike price). A call option is a contract that gives the holder the right to buy from the option seller an asset at a specified price; a put option is a contract that gives the holder the right to sell an asset at a predetermined price. Options are traded both on exchanges and over-the-counter.
A market for securities where trading is not conducted on an organized exchange but through bilateral negotiations. Often these markets are intermediated by brokers and/or dealers. Examples of OTC derivatives transactions include foreign exchange forward contracts, currency swaps, and interest rate swaps.
Bonds that provide specific monetary payments if a counterparty fails to fulfill a contract, thereby providing protection against loss in the event the terms of a contract are violated.
The amount potentially at risk over the term of a derivatives contract if a counterparty defaults. It varies over lime in response to the perceived risk of asset price movements that can affect the value of the exposure.
The current exposure adjusted to reflect the cost of replacing a defaulted contract.
A derivatives contract that involves a series of exchanges of payments. Examples are agreements to exchange interest payments in a fixed-rate obligation for interest payments in a floating-rate obligation (an interest rate swap), or one currency for another (a foreign exchange swap). A cross-currency interest rate swap is the exchange of a fixed-rate obligation in one currency for a floating-rate obligation in another currency.
A statistical estimate of the potential marked-to-market loss to a trading position or portfolio from an adverse market move over a given time horizon. VaR reflects a selected confidence level; therefore, actual losses during a period are not expected to exceed the estimate more than a prespecified number of times.
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190. Capital Controls: Country Experiences with Their Use and Liberalization, by Akira Ariyoshi, Karl Habermeier, Bernard Laurens, Inci Ötker-Robe, Jorge Iván Canales Kriljenko, and Andrei Kirilenko. 2000.
189. Current Account and External Sustainability in the Baltics, Russia, and Other Countries of the Former Soviet Union, by Donal McGettigan. 2000.
188. Financial Sector Crisis and Restructuring: Lessons from Asia, by Carl-Johan Lindgren, Tomás J.T. Baliño, Charles Enoch, Anne-Marie Guide, Marc Quintyn, and Leslie Teo. 1999.
187. Philippines: Toward Sustainable and Rapid Growth, Recent Developments and the Agenda Ahead, by Markus Rodlauer, Prakash Loungani, Vivek Arora, Charalambos Christofides, Enrique G. De la Piedra, Piyabha Kongsamut, Kristina Kostial, Victoria Summers, and Athanasios Vamvakidis. 2000.
186. Anticipating Balance of Payments Crises: The Role of Early Warning Systems, by Andrew Berg, Eduardo Borensztein, Gian Maria Milesi-Ferretti, and Catherine Pattillo. 1999.
185. Oman Beyond the Oil Horizon: Policies Toward Sustainable Growth, edited by Ahsan Mansur and Volker Treichel. 1999.
184. Growth Experience in Transition Countries, 1990–98, by Oleh Havrylyshyn, Thomas Wolf, Julian Berengaut, Marta Castello-Branco, Ron van Rooden, and Valerie Mercer-Blackman, 1999.
183. Economic Reforms in Kazakhstan, Kyrgyz Republic, Tajikistan, Turkmenistan, and Uzbekistan, by Emine Gürgen, Harry Snoek, Jon Craig, Jimmy McHugh, Ivailo Izvorski, and Ron van Rooden. 1999.
182. Tax Reform in the Baltics, Russia, and Other Countries of the Former Soviet Union, by a staff team led by Liam Ebrill and Oleh Havrylyshyn. 1999.
181. The Netherlands: Transforming a Market Economy, by C. Maxwell Watson, Bas B. Bakker, Jan Kees Martijn, and Ioannis Halikias. 1999.
180. Revenue Implications of Trade Liberalization, by Liam Ebrill, Janet Stotsky, and Reint Gropp. 1999.
179. Disinflation in Transition: 1993–97, by Carlo Cottarelli and Peter Doyle. 1999.
178. IMF-Supported Programs in Indonesia, Korea, and Thailand: A Preliminary Assessment, by Timothy Lane, Atish Ghosh, Javier Hamann, Steven Phillips, Marianne Schulze-Ghattas, and Tsidi Tsikata, 1999.
177. Perspectives on Regional Unemployment in Europe, by Paolo Maura, Eswar Prasad, and Antonio Spilimbergo. 1999.
176. Back to the Future: Postwar Reconstruction and Stabilization in Lebanon, edited by Sena Eken and Thomas Helbling. 1999.
175. Macroeconomic Developments in the Baltics, Russia, and Other Countries of the Former Soviet Union, 1992–97, by Luis M. Valdivieso. 1998.
174. Impact of EMU on Selected Non-European Union Countries, by R. Feldman, K. Nashashibi, R. Nord, P. Allum, D. Desruelle, K. Enders, R. Kahn. and H. Temprano-Arroyo. 1998.
173. The Baltic Countries: From Economic Stabilization to EU Accession, by Julian Berengaut, Augusto Lopez-Claros, Françoise Le Gall, Dennis Jones, Richard Stern, Ann-Margret Westin, Effie Psalida, Pietro Garibaldi. 1998.
172. Capital Account Liberalization: Theoretical and Practical Aspects, by a staff team led by Barry Eichengreen and Michael Mussa, with Giovanni Dell’Ariccia, Enrica Detragiache, Gian Maria Milesi-Ferretti, and Andrew Tweedie. 1998.
171. Monetary Policy in Dollarized Economies, by Tomás Baliño, Adam Bennett, and Eduardo Borensztein, 1998.
170. The West African Economic and Monetary Union: Recent Developments and Policy Issues, by a staff team led by Ernesto Hernández-Catá and comprising Christian A. François, Paul Masson, Pascal Bouvier, Patrick Peroz, Dominique Desruelle, and Athanasios Vamvakidis. 1998.
169. Financial Sector Development in Sub-Saharan African Countries, by Hassanali Mehran, Piero Ugolini, Jean Phillipe Briffaux, George Iden, Tonny Lybek, Stephen Swaray, and Peter Hayward. 1998.
168. Exit Strategies: Policy Options for Countries Seeking Greater Exchange Rate Flexibility, by a staff team led by Barry Eichengreen and Paul Masson with Hugh Bredenkamp, Barry Johnston, Javier Hamann, Esteban Jadresic, and Inci Ötker. 1998.
167. Exchange Rate Assessment: Extensions of the Macroeconomic Balance Approach, edited by Peter Isard and Hamid Faruqee. 1998
166. Hedge Funds and Financial Market Dynamics, by a staff team led by Barry Eichengreen and Donald Mathieson with Bankim Chadha, Anne Jansen, Laura Kodres, and Sunil Sharma. 1998.
165. Algeria: Stabilization and Transition to the Market, by Karim Nashashibi, Patricia Alonso-Gamo, Stefania Bazzoni, Alain Féler, Nicole Laframboise, and Sebastian Paris Horvitz. 1998.
164. MULTIMOD Mark HI: The Core Dynamic and Steady-State Model, by Douglas Laxton, Peter Isard, Hamid Faruqee, Eswar Prasad, and Bart Turtelboom. 1998.
163. Egypt: Beyond Stabilization, Toward a Dynamic Market Economy, by a staff team led by Howard Handy. 1998.
162. Fiscal Policy Rules, by George Kopits and Steven Symansky. 1998.
161. The Nordic Banking Crises: Pitfalls in Financial Liberalization? by Burkhard Drees and Ceyla Pazarbaşioğlu. 1998.
160. Fiscal Reform in Low-Income Countries: Experience Under IMF-Supported Programs, by a staff team led by George T. Abed and comprising Liam Ebrill, Sanjeev Gupta, Benedict Clements, Ronald McMorran, Anthony Pellechio, Jerald Schiff, and Marijn Verhoeven. 1998.
159. Hungary: Economic Policies for Sustainable Growth, Carlo Cottarelli, Thomas Krueger, Reza Moghadam, Perry Perone, Edgardo Ruggiero, and Rachel van Elkan. 1998.
158. Transparency in Government Operations, by George Kopits and Jon Craig. 1998.
Note: For information on the title and availability of Occasional Papers not listed, please consult the IMF Publications Catalog or contact IMF Publication Services.