exchanges. Organized exchanges operate central- ized markets where buyers and sellers submit or- ders. ese orders are matched, and prices deter- mined in an auction process. Historically, these were face-to-face “double” auctions conducted on exchange trading oors. Increasingly, however, the auctions are computerized.
clearinghouse. Aer clearing, Mr. S and Ms. B have no contractual relationship. Instead, Mr. S has a contract to sell to the clearinghouse, and Ms. B has a contract to buy from the clearing- house. us, even if Mr. S does not perform on his contractual obligation, Ms. B will receive all due her; the clearinghouse makes her whole.2
e prices determined in exchange auctions
are transparently observable. Since individu- als with information can buy or sell derivatives, their trades aect prices and cause these prices to reect their information. In this way, deriva- tives trading can aggregate information dispersed among myriad market participants, and prices re-
ect this aggregated information. In this way, de-
rivatives markets contribute to “price discovery.”
Exchanges perform a variety of other functions in addition to operating auction markets. ey cre- ate derivatives contracts with standardized terms. For instance, just as Henry Ford said you can buy a Model T in any color as long as it is black, you can buy any kind of oil future on the New York Mercantile Exchange as long as it is for delivery of 1000 barrels of light sweet crude oil in Cushing, Oklahoma.
Such standardization has advantages and disad- vantages. On the one hand, it tends to contribute to liquidity by concentrating trading activity on a single benchmark contract. On the other hand, it precludes market users from customizing terms to accommodate their specic preferences and information.
Modern exchanges also typically operate “clear- inghouses,” or enter into arrangements with third parties whereby their contracts are cleared. In a cleared market, once Mr. S and Ms. B have agreed to a price, the trade is submitted to the
at is, the clearinghouse becomes the seller to
every buyer and the buyer to every seller. is means that an individual is not subject to the risk that the party with whom she originally dealt will perform on his contractual obligation. is makes cleared derivatives fungible; the identities of buyer and seller are irrelevant.
Exchanges also engage in oversight of those who trade on their markets. Since they operate cen- tralized markets, they can also collect—and pro- vide to regulators—information about all trading activity, and the positions held by all market par- ticipants.
e other major venue for derivatives trading is
the over-the-counter (OTC) market. e OTC market is not centralized; it is decentralized. Buy- ers and sellers can interact in a variety of ways.
ey can negotiate deals by phone. ey can use
the services of brokers. ey sometimes use elec- tronic platforms that bear some similarities to ex- changes.
Moreover, OTC derivatives are not necessari y standardized by a central organization like an ex- change, although many OTC derivatives are highly standardized. Traders in OTC markets can cus- tomize the terms of “bespoke” transactions to suit their particular hedging or speculative objectives.
e type of contract that can be traded OTC is lim-
ited only by the imagination of market participants and the ability to nd a willing trading partner.
is is an overly simplied description of how clearing works. In practice, it is far more complicated. I will address some of these complica-
tions below. For more detail, see Telser (1981), Edwards (1983), Pirrong (2008, 2009).
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