The value of a derivatives contract is dependent upon or derived from one or more underlying assets, such as a commodity, bond, equity, currency, or other reference value such as an interest rate or credit risk.
Derivatives play an important role in the capital markets and the broader economy. Companies in every state use derivatives to protect against risks that are inherent in their businesses. Derivatives are often and inappropriately portrayed as unregulated, arcane, and excessively risky instruments.
Many derivatives fall into the category of over-the-counter (OTC) derivatives, which means that their terms are privately negotiated between two parties rather than traded on an exchange with standardized terms. Examples of contracts that can be traded as OTC derivatives include:
• Forwards – contracts to buy or sell assets at a future date based on a price specified today.
• OTC Options – contracts to buy or sell an asset at a given price within a specified date.
• Swaps – contracts to exchange cash flows on an agreed schedule.
• Credit Default Swaps – contracts where a buyer makes a payment to a seller in return for a promise that the seller will compensate the buyer if a specified credit event occurs.
OTC derivatives offer flexibility in reducing risk exposure. For example, an electric utility can use OTC derivatives to hedge the risk of increases in fuel costs on the specific quantity of fuel it plans to purchase over a period of time so that its customers are protected against rate increases. OTC derivatives also help financial institutions hedge their exposure to credit risk, which then helps the financial institution expand their lending capabilities.
As part of the response to the role that credit default swaps played in the troubles of insurance company American International Group, legislation was introduced in 2009 to increase oversight of the derivatives market. That legislation became Title VII of the Dodd-Frank Act.
Under the Dodd-Frank Act, swaps that are accepted for clearing by at least one central counterparty (CCP) will become required to clear. This means instead of an OTC agreement between two parties, the CCP will step in and buy the swap from the seller and then sell it to the buyer. In doing so, the CCP will take on the responsibility for guaranteeing the contract. Because the CCP will be required to hold large amounts of capital and will be closely monitored, this can reduce the risk that one counterparty default will trigger a chain of defaults in swaps markets. These cleared swaps also will be required to be traded on an exchange or a swap execution facility (SEF) if they are made available for trading.