Latin American Capital Markets

DESIGNING A DERIVATIVES COMPLEMENTTO CASH MARKETS 359regulators require dissemination of prices in real time, in fact, market participation isfacilitated by real time access to such prices and in most cases direct users of the marketdemand such access. Information on the depth of the market and the configurationof bids and offers also promotes confidence in prices achieved and avoidssurprises regarding settlement prices and liquidity.Depending on the structure of the market, less liquid markets can use marketmakers, single price auctions, or average price mechanisms without necessarily adverselyaffecting the purity of price discovery and the effectiveness of hedges. In fact,many markets provide special treatments for large orders or permit only partial quantitiesto be disclosed as part of an electronic bidding process to promote liquidity ormoderate the price changes introduced by large transactions.In any case, price transparency, in addition to permitting price discovery andfacilitating hedging, assists in maintaining the liquidity necessary to offset expeditiouslycontracts or to liquidate positions under normal trading conditions and in volatilemarkets or in the event of customer or firm defaults. 31 This, in turn, permits preventingthe accrual of losses caused by price changes and ensures that risk shifting is possibleby permitting hedges to be adjusted in a timely way.Because centering all price information maximizes the liquidity and operabilityof the markets, in some jurisdictions, all trading interest in exchange-relatedfinancial contracts, even those taken over the counter, must be reported to exchangemarkets. 32 Off-market trades are reported to prevent so-called free riding, to ensurethat market-quoted prices are representative and that interests moving into and offmarkets do not have a destabilizing effect.These measures are intended to promotebest execution, help maintain continuous liquidity, and prevent market abuse. 33 Addedtransparency of exposures may be especially helpful in smaller markets in promotingefficiency and reducing spreads.Some transparency issues are unique to the fair operation of derivatives markets,in particular, futures markets. For example, in the case of contracts based on commodityreference prices, basis risk is the risk arising from a difference in price betweenthe standardized traded commodity or contract deliverable and the commodity beingheld or produced by the party seeking risk management services. In order to design a31 There is significant anecdotal evidence that in times of uncertainty, trading volume migrates from off-exchange (lesstransparent) to on-exchange (more transparent) venues. Some examples are the trading that moved to the IntercontinentalExchange (ICE) and the New York Mercantile Exchange in the wake of the collapse of Enron and the tradingof large institutions during the 1987 market crash.32 See, for example, the information regarding Brazil in CFTC (1999b).33 Other jurisdictions (such as the United Kingdom) also obtain transaction information. In some jurisdictions, retailcustomers must transact in an exchange venue to permit regulators to be sure that appropriate customer protectionsare applied.Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub