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How derivatives markets work

Derivatives markets serve an essential function in the growth of economies and the efficient operation of industries and companies.

Derivatives are contracts based on the value now, for the delivery or settlement in the future, of an underlying physical or financial asset, for example crude oil, natural gas, electricity, emissions, cotton, currencies or interest rates. They enable price discovery, which is vital for informing current decisions about future consumption, investments, and resource allocation. In doing so, derivatives provide a critical risk management function by allowing anyone with exposure to an asset to hedge that exposure across a range of time maturities.

There are two types of derivatives markets:

  • Exchange-traded derivatives markets, and
  • Over-the-counter (OTC) markets.

OTC is a broad term, referring to trading amongst decentralized networks of buyers and sellers, usually intermediated by a small number of highly interconnected financial institutions such as brokers. OTC trading can also take place on a bilateral basis, whereby the counterparties have direct relationships with each other.

In contrast, exchange trading takes place in a centralized order book and on a multilateral basis, i.e., all buyers and sellers interact with each other at the same time akin to a many-to-many model as seen in Exhibit 1.

Exhibit 1: Different models of trading in derivatives markets

Source: Oxera

Derivative Trading Types

Exchange-traded derivatives markets such as futures markets offer highly liquid and standardized contracts, and trading activity in these contracts is predominantly institutional -- with the majority of transactions taking place between commercial firms primarily seeking to hedge their exposure to an underlying asset and financial institutions and other liquidity providers.

All exchange-traded derivatives transactions and many OTC transactions are cleared by a central counterparty known as a Clearing House, which serves as the buyer to every seller and the seller to every buyer. ICE’s Clearing Houses, for example, deliver stability and risk management across global derivatives markets operated by ICE. With six clearing houses serving key derivatives asset classes across the U.S., U.K., Europe, Canada and Singapore, the ICE clearing platform drives operational and capital efficiency regardless of where market participants transact.

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