Bob Currie discusses some of the key points discussed in the WFE’s paper that calls for a refresh of public policy on derivatives to support their use in regulated, lit environments.
By providing an accurate mechanism for pricing specific types of risk – the price of an equity, for example, or a barrel of oil – derivatives give users “more power to manage risk than any other financial instruments.”
So says the World Federation of Exchanges (WFE) in a recent report, Shining a Light on Derivatives (WFE, March 2025) which highlights the importance of exchange-traded and centrally-cleared derivatives in enabling market participants to manage the risks that confront them in financial markets.
Listed markets represent the “safe core” of derivatives, just as they do for equities and other financial instruments, claims the report. “It is vital for the health not just of the listed markets, but for finance more generally, that we ensure that they continue to do so.”
However, for retail investors, for public bodies, for small companies and some other categories of market participant, their access to derivatives trading is often more limited than it is for securities and this constrains the risk management benefits available through this channel.
Moreover, derivatives exchanges – as providers of the price formation “on which the whole market relies” – may find that more lightly regulated competitors are applying this price information to conduct their own trades outside of the public gaze. This result, suggests the WFE, is a fragmented marketplace working to the advantage of a few powerful intermediaries, but sometimes failing to offer the same level of benefit to their customers.
As its foundation, the report suggests a need to revisit the balance between exchange-traded and over-the-counter derivatives (OTC) and, more generally, between lit and dark trading markets.
Exchange-listed derivatives, in offering standardised contracts, deliver “transactional transparency” and the benefits of liquidity and market integrity. “This”, says the report, “is why the role of exchanges – and clearing houses, to neutralise the related counterparty risk – should be nurtured and favoured in public policy.”
The authors note that OTC derivatives can be useful when they solve a specific problem for a specific user. This, in turn, may result in a “symbiosis” between the listed and OTC derivatives markets — for example, a dealer in the commodities markets might use a listed oil derivative as a proxy to hedge a forward-dated transaction in a different, but not heavily traded, grade of oil.
However, not all OTC derivatives transactions are tailored in any meaningful sense, the report argues. OTC contracts may be traded that offer the same exposure – in terms of size and maturity – to those available on exchange, “but without any of the public-good obligations associated with lit public markets”.
As an example, it suggests that swaps started as a bespoke instrument. However, relatively quickly they were being traded with maturity dates that align with interest-rate futures, but without the price discovery advantages that exist in listed derivatives markets.
For the WFE, derivatives are sometimes the subject of “irrational hostility” from those who fail to take into account key differences with other financial products. This is particularly the case for cash-settled derivatives that make up a large share of the market.
One problem, the report indicates, is that some critics do not have an accurate picture of the true size of the derivatives market – and, by implication, they may overstate the systemic risks associated with this market segment.
Many participants, especially dealer intermediaries, employ a range of offsetting contracts, which must be netted down in the event that a party falls bankrupt. In terms of notional amount, this activity may aggregate to a few hundred trillion dollars. “In reality, the amount that would change hands, if all derivatives were closed out, would be about one hundredth of that, since it would be the mark-to-market value of the contracts, netted down to reflect economic offsets,” says the report.
Moreover, those mark-to-market amounts are typically well collateralised. When centrally-cleared, central counterparties (CCPs) play an essential role in mitigating counterparty risk, requiring posting of initial and variation margin, ensuring that collateral quality aligns with the specified eligibility criteria, and backing this with additional resources as part of the CCP’s risk management framework.
“Let us remember that the G20 in 2009 chose not to restrict derivatives but to ensure they were traded in the best possible environment,” says the report.
