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Now since we have a basic idea regarding what derivatives really are and the function that they perform, it time to get into a little more detail.
At this point, it is essential to introduce the concept of exchange traded derivatives and over the counter derivatives. We have briefly brushed on them in the previous few articles.
However, now we will understand them in more detail. The idea is to grasp why this bifurcation amongst the type of derivatives matters and how one can make best use of both types of derivatives.
The defining feature of the exchange traded derivatives is that they are standardized contracts. Let’s use an example to explain this. Let’s say we want to fix the price of 1260 kgs. of wheat that we expect to produce in the harvest season. We want to find a buyer in the derivatives market. Now the issues that we will face are:
The point, therefore is , that making buyers and sellers meet when they have extremely specific needs is a difficult job and cannot be done on an exchange.
In contrast, exchange traded derivatives are standardized contracts. Each contract will have a fixed expiration data, each contract will be for the same amount of quantity i.e. 100 kgs (assume). Hence, all the above mentioned difficulties become redundant.
The biggest and differentiating factor of exchange traded derivatives is that they are standardized contracts.
Since, exchange traded derivatives can be brought off the market at any given point of time, they provide the users with a lot of opportunity to offset their previous contract as and when required.
Consider the case of a farmer who has agreed to sell wheat to a merchant at a later data at a price fixed today. Later on, the farmer believes that he can get a better price in the market and wants to reverse the contract, what shall he do? In case of a customized contract, the farmer will have to negotiate with the other party and hope that they agree to reverse the contract. This puts the farmer at a competitive disadvantage if they change their mind.
This is not the case with exchange traded derivatives. Exchange traded derivatives can be offset in two ways:
Since both of these actions can easily be performed in a matter of seconds and without any negotiations, exchange traded derivatives are much more user friendly than their counterparts.
The exchange traded derivatives provide another major advantage. In case of exchange traded derivatives, neither party is directly facing a counterparty risk. This is because neither party is actually directly dealing with the other party.
Let’s say, A enters into a contract with the exchange wherein exchange goes short and A goes long. The exchange will simultaneously enter into another contract with B wherein the exchange takes an offsetting position i.e. goes long.
Hence, both parties are contractually bound to the exchange. Since the exchange is a credible counterparty, the chances of default are greatly reduced making exchange traded derivatives a safer bet when it comes to credit risk.
Most traders around the world take it as a given that the exchange will never default on its liabilities. The day the exchange defaults, it will be out of business.
The exchange is a neutral body. Also, exchanges are subject to a lot of regulation. It is for these reasons that exchange traded derivatives are a safer bet. When one trades in exchange traded derivatives, it is unlikely that they will come across a scenario wherein a few participants have cornered the market i.e. have complete control over the commodity in the market.
Events like short squeezes do happen but they are not as easy to execute while trading exchange traded derivatives because the exchange has to publish information about all the major trades executed on a given day. This prevents the big parties from cornering the markets.
Lastly, exchange traded derivatives have a lot of market depth. This means that these markets are highly liquid. Hence, if any person holding exchange traded derivatives wants to reverse their position, they will easily find a counterparty to sell their stake to or make an opposite bet against.
Since the markets are so liquid, these parties can be found at the click of a button and the stake can be sold without any major loss in value.
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