Latin American Capital Markets

DESIGNING A DERIVATIVES COMPLEMENTTO CASH MARKETS 341out cost. Because such transactions traditionally are not standardized and hence notfungible, OTC derivatives positions reduce basis risk, but usually are difficult to adjustor offset once established, as one must return to the original counterparty to do soand market conditions may not favor renegotiation. 4The challenge of developing exchange-traded derivatives markets, which canpermit effective risk transfer and, by centralizing demand, foster better price discovery,is to combine liquidity and hedging utility—that is, to balance the standardizationnecessary for trading with a design that limits basis risk or the differential between theprice of the exchange-standardized product and the actual cash commodity (Martel2001). Not all jurisdictions can support exchange markets, and for those which cannot,variants of more tailored OTC solutions for risk management may be desirableif properly designed, understood, and monitored. 5Designing Derivatives Contracts and MarketsPolicymakers who seek to design or encourage the design and development of successfulderivatives markets must combine an analysis of demand for a product withdevelopment of an appropriate infrastructure, oversight framework and supportiveeconomic environmentThe design might be based on a top-down, bottom-up, or hybriddevelopment approach. Figure I I-1 illustrates the traditional view of the evolutionof derivatives markets.The best approach depends on the status of the preconditionsin the jurisdiction seeking to develop a market This section discusses some ofthe product development issues policymakers should considerThe Underlying Cash MarketIn theory, any financial asset can serve as the basis for an exchange-traded derivativescontract. In practice, however, relatively few financial assets have served successfully as4 Basis refers to the difference between the spot or cash price of a commodity and the price of the nearest futurescontract for the same or a related commodity.Today, in some jurisdictions, there are arrangements for clearing OTCtransactions, and exchange products have used flexible, tailored structures or limited auctions, to some extent blurringthe early distinctions between exchange and OTC products. Master agreements, which facilitate netting, are intendedto accomplish the netting of payments and obligations that is required by law and exchange rules through acentral counterparty.These arrangements still depend on agreement as to the closeout price.5 For an excellent discussion of the evolution of markets and how private cash markets and forward markets can beprecursors for successful exchange futures markets or cleared OTC markets, see Kroszner (1999). Successful marketsare more likely to evolve over time when fostered by the right conditions than to be created out of whole cloth (Martel2001).Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub