Chapter 2

Exchanges, OTC Derivatives, DPCs and SPVs

A too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences.

Ben Bernanke (1953–)

2.1 EXCHANGES

2.1.1 What is an exchange?

In derivative markets, many contracts are exchange-traded. An exchange is a central financial centre where parties can trade standardised contracts such as futures and options at a specified price. An exchange promotes market efficiency and enhances liquidity by centralising trading in a single place. The process by which a financial contract becomes exchange-traded can be thought of as a long journey where a critical trading volume, standardisation and liquidity must first develop.

Exchanges have been used to trade financial products for many years. The origins of central counterparties (CCPs) date back to futures exchanges, which can be traced back to the 19th century (and even further). A future is an agreement by two parties to buy or sell a specified quantity of an asset at some time in the future at a price agreed upon today. Futures were developed to allow merchants or companies to fix prices for certain assets, and therefore be able to hedge their exposure to price movements. An exchange was essentially a market where standardised contracts such as futures could be traded. Originally, exchanges were simply trading ...

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