Microstructure Developments in Derivative Markets


Executive in Residence, Kogod School of Business, American University


Derivative contracts differ from securities in some important respects. Securities convey rights of ownership, such as amounts (or proportion) of compensation payable to holders of the security, and voting rights. Yet, derivatives do not provide ownership. Instead, they are executory contracts obliging their respective counterparties to perform specific duties. For commodity futures contracts, these duties require the short (sell) side of the contract to deliver specified quantities of a commodity to a designated place on a date certain and the long (buy) side to pay the contract price on taking delivery. More often, settlements of derivative contracts, even those specifying delivery terms, are at cash amounts that approximate their notional delivery. The distinction is an important one. Because ownership rights can be diluted, securities are issued in limited amounts. Those limits result in an upper bound on the number of claims that can be offered for sale. In contrast, an executory contract is created whenever a long and short side can agree on a price at which they are willing to honor their commitments.

Besides the penultimate obligations of a derivatives contract, the duties of counterparties to exchange-traded derivative contracts include terms intended to lessen counterparty risk exposure owing to subsequent nonperformance ...

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