Mapping the two-way risks in exchange-traded platforms

Venkatachalam Shunmugam 19 March 2011

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Over the past three decades derivatives have become critical to the existence of transparent, exchange-traded markets the world over. Particularly in the last few years, the exchange-traded derivatives segment has witnessed remarkable growth driven by path-breaking innovations in products and technology – largely spurred by competition. The benefits have been many.

Derivatives have helped a diverse base of economic stakeholders manage their risks in the most cost-effective way – no small feat in this era of rapid global information flow. Moreover, by facilitating a transparent convergence of vast information from a broad base of stakeholders, exchange-traded derivatives also enable efficient price discovery. This not only helps the immediate stakeholders make informed decisions, it also gives a cue to the policymakers formulating policies aimed at maintaining economic stability and, by extension, socio-political stability.

The risks with derivatives

While dimensions such as electronification, leverage, and a robust clearing mechanism of exchange-traded derivatives markets have provided participants with easier access to the exchange-traded derivative platforms, they have also, at the same time, exposed these markets, their efficiency, and their respective immediate and distant stakeholders (i.e. the real economy) to various risks. These risks can be classified into two categories:

  • One relates to the unregulated participation, which could lead to imperfect functioning of derivative markets; and
  • the other pertains to the wrong signals that these markets could provide to the real economy because of their imperfect functioning (see Figure 1).

Figure 1. Risks to and from derivatives markets

Risks to and from derivative markets

Exchange-traded derivative markets for various asset classes perform two primary economic functions:

  • Price discovery, and;
  • Price risk management.

However, their performance is vulnerable to a slew of risks in these very markets. The risk to the price discovery efficiency of these markets arises from price manipulation by participants either taking large positions or taking advantage of leverage that these markets provide. As a result, the prices that transparently emanate from exchange-traded platforms mislead the real economy more indirectly or directly make the process of risk management on these platforms costlier for the stakeholders of the real economy.
Frequent policy interventions by governments in the underlying markets and/or derivatives markets also pose challenges to the process of price discovery on exchange-traded platforms. Such interventions, which include restrictions on physical trading, changes in international trade policies, support prices, restrictions on exchange-traded platforms, etc, impede the price discovery process by taking away participants’ attention from the fundamentals of the underlying assets into mundane policy or institutional aspects. At times, participants lose trading interests in these asset classes leading to the failure of exchange-traded markets to discover right prices of underlying asset classes.

Contract design also plays a critical role in making the price signals (from exchange-traded derivatives) useful to the stakeholders of the real economy. It requires that adequate efforts are taken to properly identify the relevant underlying market and that the derivative contract specifications are in line with those of the underlying cash market practices. Additionally, it is necessary that the platforms make sure that their products are keeping up with the changing market dynamics. For example, the problem of non-convergence between cash (spot) and futures prices of wheat on futures contract expiry in select US commodity futures platforms was essentially a problem of contract design. A study by Hieronymus (1977) warns that “When a contract is out of balance the disadvantaged side ceases trading and the contract disappears.”

If the process of price discovery does not function in alignment with underlying market fundamentals, it may pose a threat to the relevance of derivatives markets to stakeholders of the real economy. Attempts to manipulate the market or interfere in the market’s natural price discovery process are a serious threat to the stability of the financial sector and the overall economy as they not only increase systemic risk and risk of contagion but could also act as a catalyst to financial disruption (Dodd 2003).
Besides, financial default risk and physical delivery default risk have the potential to impair the price risk management mechanism. Such defaults as they happened on the credit default swap and collateralised debt obligation markets in the US have the potential to bring to halt functioning of an entire economy through the domino effect of related participants in related asset classes on over-the-counter markets. Although an exchange-traded market provides for counterparty protection of financial risks, it is essential that these risks are adequately covered through the market’s own regulatory requirements. How far such risks can be controlled is a function of how robust an exchange-traded platform’s collateral management policies are and how robust their mark-to-market mechanism is.

Behavioural link to market risks

A majority of risks caused to markets directly or indirectly by participants can be better understood if markets are studied from the perspective of participants’ behaviour, which is expected to be rational according to the efficient market theory that economics teaches us. Risks to efficient functioning of markets arise from individual and/or collective irrationality. At times, collective irrationality may also be the outcome of individually rational thinking/acting. Participants’ intrinsic reactions to various pieces of available information and to upward or downward trends could well turn out to be collectively irrational, even if they are rational at the individual level, just like an ant’s circular mill (Surowiecki 2006).

In his ”greed” to chase maximum returns, a participant tends to believe that his strategies, backed by modern technology at his disposal, can help him alter the collective thinking process of the market to his individual profits. But this attempt actually works or goes against the basic principles of economics. Therefore, such individual (apparently) rational actions could turn out to be collectively irrational i.e. irrational for the market as a whole. As “greed” multiplies, it makes markets and participation in the same unsustainable in the long term. Such “greed”, as it permeates collectives and gets expressed in markets, leads to what Robert Schiller terms “Irrational Exuberance”. Only effective external regulation by independent regulators, who are detached from markets yet have a bird’s eye view, can identify such individual or collective irrational behaviour and can take appropriate actions to prevent it from building up.

Similarly, markets can get overwhelmed by “fear” i.e. anticipation/awareness of danger ahead. What, among other things, differentiates human beings from animals is their ability to think about their future and anticipate what it could hold for them. However, if their expectations turn negative, the damage could be due to the influence of these expectations rather than by the changes in the real economy. While it is natural that human emotions get expressed in markets, the fact that these result in extreme price swings– unconnected from the fundamentals – harms both the financial market and stakeholders. It is the job of regulators to limit such swings. But what is a rational level? Maybe history can guide.

Adequate and evolving regulatory tools – a must

Rational decisions at the individual level can turn into collectively irrational behaviour, as discussed above. This can lead to systemic risks even in exchange-traded derivative markets, irrespective of the asset classes these markets operate for. In reaction market regulators have used various tools to prevent individual or collective irrationality from building up in these markets from time to time. However, the use of these tools vanished in derivative markets in several developed economies in recent years – they were viewed as a hindrance to the natural operation of business cycles.

However, most debates and reform-initiatives, internationally, in the wake of the recent financial crisis, seem to have brought back to focus the necessity of a prudent use of these regulatory tools in keeping exchange-traded derivative markets free from the contagion of less/unregulated interconnected markets, thereby ensuring stability in the overall economy.

Figure 1 shows that regulators worldwide have been using various tools to rid markets of different risks. Of various tools, dynamic (effective) utilisation of margins (and its variants such as additional margins and special margins), alongside mark-to-market margins, hold the key to containing risks of price manipulation and financial default, which add to systemic risk. Besides, position limits and price limits can also be used to rein in the possibility of price manipulation.

While the use of various regulatory tools and the degree of regulation vary from market to market based on the basis of maturity, the dynamism that characterises markets calls for continuous evolution of regulation and regulatory tools.

The views expressed here are the author's own.

References

Dodd, Randall (2003), “Consequences of Liberalising Derivatives Markets Financial”, Policy Forum Derivatives Study Centre.
Dodd, Randall (2004), “Derivatives Markets: Sources of Vulnerability in US Financial Markets”, Derivatives Study Centre.
Gensler, Gary (2010), Opening Statement at Meeting of The Agricultural Advisory Committee.
Hieronymus, TA (1977), Economics of Futures Trading for Commercial and Personal Profit, Second Edition.
Irwin, Scott H, Philip Garcia, Darrel L Good, and Eugene Kunda (2009), “Convergence Performance of CBOT Corn, Soybean and Wheat Futures Contracts: Causes and Solutions”, Marketing and Outlook Research Report, 2009-02.
Shunmugam, Venkatachalam (2010), “Need for pragmatic regulation of markets – the takeaway from the recent financial crisis”, Macroeconomics and Finance in Emerging Market Economies; Routledge.
Surowiecki, James (2006), “The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations”, Random House, Inc.
Swan, Edward J (2000), “Building the Global Market, A 4000 Year History of Derivatives”, Kluwer Law International; First edition, ISBN-10: 9041197591.

 

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Topics:  Financial markets International finance

Tags:  financial regulation, derivatives

Chief Economist, Multi Commodity Exchange of India Ltd., Mumbai

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