Latin American Capital Markets

DESIGNING A DERIVATIVES COMPLEMENTTO CASH MARKETS 349Trading Facility StructureA wide range of derivatives trading facilities exists around the world today, and, basedon the historical trading experience of each, no specific combination of attributes appearsto be optimal from the standpoint of market activity. There are active marketsthat use an electronic trading platform exclusively, and there are active markets thatstill use the open outcry (continuous auction) method. Likewise, not all successful derivativesmarkets use pure continuous auctions; some use market-maker systems, whileothers use other price discovery methods, such as periodic calls, price indications, orsingle price auctions. Like the contractual product, the market structure must take intoaccount the likely level of liquidity, the cash market for the product that provides thereference value, the type of market participants, and the desired level of transparency.An additional aspect of the operability of exchange-traded models that is difficultto assess in advance and yet critical to long-run success is the attraction of users,including speculative capital. New electronic technology makes it economic to operatemarkets that have limited volume and smaller contracts, or that represent nicheinterests, thereby providing more flexibility to market and contract designers than existedwhen "bricks and mortar" markets were the rule. However, the participation ofcommercial interests alone may not be sufficient to support active trading using a traditionalexchange format, as trading interest is essential to the ability to offset contracts.Of course, over time, sufficient market liquidity may evolve. Furthermore, inemerging or created markets, it may be necessary to identify and develop users. Forexample, in the United States, small farmers usually sell their crops forward and usefutures markets through specialist intermediaries that may be cooperative organizations,farm management organizations, grain elevators, or storage facilities or throughfacilities arranged through lenders. In some jurisdictions, the government (or the privatesector) organizes collective purchasing entities that export commodities, andthese entities undertake risk management, passing on some of the price benefits tothe underlying producer.These arrangements reflect that the use of derivatives marketsrequires some expertise that, where unavailable, must be developed.In addition, to permit effective offsetting of risk, particularly if commercialstend to operate from one side of the market, other sources of liquidity may be required.15 Such liquidity requires the more or less continuous presence and potentiall5 The recent failure of a number of so-called business-to-business market models is an example of this problem. Exchangesusually interview potential users of the market when designing contracts. With the new electronic technology,some cash markets (for example, chemicals) participants, having developed a cash market, have requested the assistanceof an existing futures exchange to provide a risk management market to ensure the necessary liquidity andback-office support necessary for such a market to succeed.Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub