A properly functioning derivatives market needs the presence of a diverse set of market participants with both long and short positions, as well as greater capacity and transparency in the flows and positions of derivatives.
The author has worked in the U.S. derivatives market for about 30 years. She draws on her experiences to emphasize three factors necessary to ensure a robust derivatives market: liquidity, capacity, and transparency.
How Is This Article Useful to Practitioners?
Despite the usefulness of derivatives in terms of managing risk, enhancing liquidity, saving costs in strategy implementation, and gaining exposure to commodities or emerging markets, they pose some perils. Derivatives have the potential to add to the broader systemic risk in a turbulent market because their values can vary drastically from their model-derived prices during times of higher-than-expected volatility. The author points out that the full value of liquidity risk is often not depicted in derivatives pricing; therefore, the initial cost of entering a derivatives strategy might not fully reflect the difficulty and cost of liquidating that strategy if the volatility level surges. In volatile and uncertain markets, liquidity risk feeds on itself as investors panic and de-risk and buyers refrain from purchasing. Behavior in volatile markets is further exacerbated by a lack of transparency in the size of positions because market participants will perceive the presence of pent-up selling pressure that may or may not be there in reality.
In the derivatives market, the dominance of one particular strategy used by market participants that lack capacity adds another dimension to liquidity crises. The author recounts the events that led up to the October 1987 stock market crash. Along with the unprecedented decline in the S&P 500 Index following bad economic news and the highest-ever level of volatility, the presence of more than $100 billion of portfolio insurance assets on the S&P 500 futures market, which had a trading volume of only $10 billion at the time, weighed the market down with perceived selling pressure.
The author also describes some recent examples of flow imbalances in the derivatives markets, such as the one in 2007 in the ABX Index markets—an index based on credit default swaps of subprime mortgages. Predominant short positions in the index were a precursor to the 2008 crisis in the credit default swaps market.
Index put options, VIX index futures, and variance swaps are suggested by the author as effective tools for mitigating liquidity risk because these derivatives increase in value with increases in volatility and declines in the underlying security. She finds that the S&P 500 futures and options market and the U.S. Treasury and eurodollar futures markets are currently the most enduring and successful markets.
The author provides useful information for practitioners concerned with risk and liquidity management. Greater transparency and visibility of positions in the derivatives market in the future will improve the functioning of market signals and pricing mechanisms that lead to equilibrium of supply and demand for derivatives. These changes might prevent or reduce the intensity of the notorious derivatives-led crises in underlying markets.