Derivatives market
Market for financial instruments derived from other assets.
Wikipedia / Wikimedia Commons
Derivatives are financial instruments—such as futures or options—whose value is derived from an underlying asset. The market where these instruments are traded splits into two main types: exchange-traded derivatives and over-the-counter (OTC) derivatives. Though many participants operate in both segments, the legal structure and trading methods differ significantly between them. In Europe, the notional value of the derivatives market is €660 trillion.
Market participants fall into four categories based on their reasons for trading: hedgers, who seek to reduce risk; speculators, who bet on price movements; margin traders, who use borrowed funds; and arbitrageurs, who exploit price differences.
On futures exchanges like Euronext.liffe and the Chicago Mercantile Exchange, standardized contracts—including options, swaps, and futures—are traded on a wide range of underlying assets. The exchange itself acts as the central counterparty, with members holding positions against it. When one party goes long (buys a contract), another goes short (sells). At the launch of a new contract, the total position is zero, so all long positions must equal all short positions. This means risk is transferred from one party to another in what is essentially a zero-sum game. By the end of June 2004, the total notional amount of outstanding positions was $53 trillion, growing to $81 trillion by the end of March 2008.
Tailor-made derivatives not traded on exchanges are handled in the OTC market. Here, investment banks act as market makers, dealing with clients such as hedge funds, commercial banks, and government-sponsored enterprises. Products always traded OTC include swaps, forward rate agreements, forward contracts, credit derivatives, and accumulators. The total notional amount of outstanding OTC positions stood at $220 trillion at the end of June 2004, rose to $596 trillion by the end of 2007, and reached $615 trillion in 2009. The OTC market is split into two segments: the customer market and the interdealer market. Customers typically trade through dealers due to high search and transaction costs. Dealers—large institutions with specialized knowledge and capital—arrange transactions for customers. To hedge the risks from these customer deals, dealers turn to the interdealer market or exchange-traded markets. They may also trade for themselves or act as market makers.
In th
- total_notional_OTC_2004
- $220 trillion
- total_notional_OTC_2007
- $596 trillion
- total_notional_OTC_2009
- $615 trillion
- total_notional_exchange_traded_2004
- $53 trillion
- total_notional_exchange_traded_2008
- $81 trillion
- total_notional_US_banks_Q2_2008
- $182.2 trillion
- number_of_commercial_banks_holding_deriv
- 975
Lore & Background
The derivatives market is composed of exchange-traded and over-the-counter segments. Exchange-traded derivatives, such as those on Euronext.liffe and the Chicago Mercantile Exchange, involve standardized contracts where the exchange acts as central counterparty. In these markets, the sum of long positions equals the sum of short positions, making it a zero-sum game. Over-the-counter derivatives are tailor-made and traded directly between investment banks and clients like hedge funds and commercial banks. Products traded OTC include swaps, forward rate agreements, and credit derivatives. The OTC market is split into the customer market and the interdealer market, where dealers hedge risks.
Reader's Guide
The derivatives market played an important role in the 2008 financial crisis. Credit default swaps and mortgage-backed securities were notable contributors. Leveraged operations generated an 'irrational appeal' for risk taking, and the lack of clearing obligations was damaging for market balance. Interdealer collateral management and risk management systems proved inadequate. The G-20's proposals for financial markets reform stress higher capital standards, stronger risk management, international surveillance of financial firms' operations, and dynamic capital rules. The market's size, measured by notional amounts outstanding, grew rapidly from 2004 to 2009, with OTC positions reaching $615 trillion in 2009. These figures provide information on market structure but are not a measure of riskiness.
Did You Know?
- The total notional amount of exchange-traded derivatives stood at $53 trillion in June 2004 and grew to $81 trillion by March 2008.
- OTC derivatives notional amounts rose from $220 trillion in June 2004 to $615 trillion in 2009.
- In the second quarter of 2008, U.S. commercial banks reported derivatives trading revenues of $1.6 billion.
- The derivatives market in Europe has a notional amount of €660 trillion.
Frequently Asked Questions
Who is Derivatives market?
Derivatives market is the collective venue where financial contracts such as futures and options are bought and sold, with their prices anchored to the performance of an underlying asset. It operates through two distinct channels: exchange-traded contracts and privately negotiated over-the-counter (OTC) agreements.
What are Derivatives market's powers/role?
Its core function is to let participants transfer, reduce, or amplify financial risk by tying contract values to another asset's behavior. Participants split into hedgers who want to lock in prices, speculators who bet on direction, and arbitrageurs who exploit pricing gaps between venues.
How does Derivatives market's story end?
As a living, evolving market rather than a narrative with a fixed finale, its most dramatic turning point came during the 2008 crisis, when OTC notional values surged past $600 trillion and U.S. banks alone carried $182.2 trillion in exposure by mid-2008. Regulatory reforms in the years since have reshaped how the OTC segment operates, but the market itself continues to grow and adapt.
Why is Derivatives market important?
With a European notional value of €660 trillion, it dwarfs the cash markets it underpins and serves as the primary mechanism for managing price risk across the global economy. Its sheer scale means that stress in derivatives can ripple through every corner of finance and the broader real economy.
What is the difference between Derivatives market's two 'realms'?
Exchange-traded derivatives are standardized, centrally cleared, and typically settled daily, while OTC derivatives are privately negotiated and carry direct counterparty risk. The legal frameworks and trading mechanics differ sharply between the two, even though many firms participate in both segments simultaneously.
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