Intricacies of Derivatives Regulation

Josef Bergt
2023

Introduction

The intricate web of financial instruments, particularly derivatives, has been a subject of considerable legal scrutiny and regulatory oversight. The Markets in Financial Instruments Directive (MiFID 2) serves as a cornerstone in this regard, providing a comprehensive framework for the classification and regulation of financial instruments, including derivatives. The Act's stipulations, offer a nuanced understanding of derivatives, encompassing a wide array of financial transactions such as futures, swaps, and options. This article aims to dissect these complex provisions, elucidating their implications for both financial institutions and individuals.

The Definition of Derivatives

Forward Contracts

Forward contracts are outlined as transactions that are to be fulfilled at a future date and whose value is directly or indirectly derived from an underlying asset. This legal definition encapsulates several key elements:

• The transaction is deferred for future fulfillment.
• An underlying asset exists.
• The transaction's value is directly or indirectly influenced by the underlying asset's price or measure.

Further categorization based on underlying assets, such as securities, foreign currencies, interest rates, and even emission certificates is possible. The scope of these contracts is expansive, covering standardized contracts like futures and non-standardized ones like forwards.

Derivative contracts are characterized as futures transactions, which diverge from spot market transactions in that the conclusion and fulfillment of a transaction do not coincide. Specifically, the price-relevant conclusion time and the value-relevant fulfillment time are separated on the timeline, with the value depending on the performance of a reference variable, the underlying asset, to which reference is made and where the value is derived from. Thus, conclusion and fulfillment are separated, and settlement occurs at a later point in time:

• Forwards: Customized contracts between two parties to buy or sell an asset at a specified price on a future date, with terms not standardized and usually not traded on exchanges but over the counter (OTC).
• Futures: Standardized contracts to buy or sell an asset at a predetermined price at a specified time in the future, traded on organized exchanges with margin requirements.
• Options: Financial instruments granting the holder the right, but not the obligation, to buy or sell an asset at a predetermined price within a given timeframe.
• Swaps: Agreements between two parties to exchange sequences of cash flows, often involving different types of financial instruments or commodities, over a specified period.

Financial Contracts for Difference (CFDs)

Financial Contracts for Difference (CFDs) are bilateral agreements where one party is obligated to pay the difference between the current market price of an underlying asset and its value at the time of the contract's initiation. These contracts can be perpetual, closed only when a counteracting transaction is initiated by the buyer.

Credit Derivatives

Credit derivatives are designed to transfer credit risks. They include instruments like Credit Default Swaps (CDS) and Total Rate of Return Swaps (TRS).

Excursus on Options Trading: Rights and Duties Matrix

the concepts of 'going long' and 'going short,' as well as 'put' and 'call,' are pivotal in the realm of options trading, each embodying distinct rights and obligations for the parties involved. Below is a matrix elucidating these terms in relation to the rights and duties conferred upon the buyer and seller of the option:

Going Long on a Call Option: When you go long on a call option, you are buying the right to purchase the underlying asset at a predetermined price (the strike price) within a specified timeframe. You pay a premium for this right, but you are not obligated to exercise the option.

Going Short on a Call Option: When you go short on a call option, you are selling someone else the right to purchase the underlying asset at the strike price. You receive a premium for this, but you are obligated to sell the asset at that price if the buyer chooses to exercise the option.

Going Long on a Put Option: When you go long on a put option, you are buying the right to sell the underlying asset at the strike price. You pay a premium for this right, but you are not obligated to exercise the option.

Going Short on a Put Option: When you go short on a put option, you are selling someone else the right to sell the underlying asset at the strike price. You receive a premium for this, but you are obligated to buy the asset at that price if the buyer chooses to exercise the option.

This matrix and the accompanying explanations serve to delineate the intricate interplay of rights and duties inherent in options trading, thereby facilitating a nuanced understanding.

Implications and Risks

The utilization of derivatives is fraught with risks that extend beyond the general insolvency risk of the counterparty. These include the risk of total loss of the invested capital and the potential requirement to provide additional funds to fulfill contractual obligations.

Source: BaFin Factsheet Financial Instruments (Derivatives)

Executive Summary:

• Derivative contracts differ from spot market transactions in that they separate the time of conclusion from the time of fulfillment, with the value being dependent on a reference variable, the underlying asset; settlement occurs at a later date.
• Forward contracts, CFDs, and credit derivatives are some of the primary types of derivatives.
• Each type of derivative comes with its own set of risks, including but not limited to, market risks, credit risks, and liquidity risks.