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Would investing in derivatives be the road to recovery?

September 2, 2020
Editor(s): Dahye Koo
Writer(s): Neharika Rastogi, Sarah Tu, Matthew William

Covid-19 has been an eye-opener, as now it has provided an opportunity for change to seep in not just from the outer covers of government policies but also from what lies within. Reviving the Australian economy, which has faced a tremendous loss along with other major powers, would not be easy. However, with the potent combination of new rules, regulations, the ‘new normal’, the flaws exposed by COVID will and can be regulated and measured.

Anyone who participates actively in the derivatives market knows that the financial markets during the uproar of Covid-19 (March) saw major turbulence which led to high volatility and market liquidity all across the globe. The turbulence caused fluctuations which were mostly due to Covid-19 and to balance the economic recession, the government followed the rules of Keynesian economics and started injecting trillions of dollars into the revival of the economy. 

While COVID 19 is a transformational opportunity for markets and government, many have used this to their benefit in restoring market liquidity with the help of government intervention. However, would derivative markets be the right choice for the revival of the Australian economy? 

Impact of Covid-19 on Derivatives:

Derivatives and forex trading have been quite significant in the past days and now with the current scenario, it is making a significant comeback. With the help of the right strategies, Keynesian economics, government intervention, and thoughtful plans, the Australian economy can boom.

From people sitting idle at home to the loss of gambling sectors, derivatives and the future market has helped investors cope up with the economic crisis arising from the pandemic.

There have been many indirect and direct effects on the future market with sharp movements in the commodities and foreign exchange markets. With a record high of 83% in the S&P 500 VIX index, COVID-19 has surely pushed us into uncharted territory but also helped the government realise where they lag.

As the virus continues, so does the impact on the economy, and as still more market movements and theories have to be understood, there have been come practical disruptions in the derivatives trading market, such as- 

  1. Increased volatility
    This uncertainty matched with increased volatility places non-bank counterparties on the wrong side of a trade unexpectedly facing margin calls or collateral demands (usually cash or liquid assets for OTC derivatives) that they cannot meet.
  2. Exchange disruption
    In the case of default in the buy and sell market, there can be a variety of disruption events. Furthermore, with lockdown in place, there have been many exchange disruptions. Therefore, as with the current market turbulence, the right and obligations of counterparties should be analysed once again.
  3.  Collateral obligations
    As counterparties often use collateral as their margining obligations, the market turbulence, in relation to the current market structure, eg- Australian real estate bubble burst, can lead to diminishing value and reduce the posted collateral value.
  4. Non-performance or termination
    In the context of Covid-19, market participants might stir legal trouble with relying on certain termination clauses or on the basis of non-performance.
  5. Commodities and energy market fluctuations
    In the commodities and energy market, where some are experiencing low spot price levels prior to COVID-19, price is experiencing an increase in volatility. The gas prices are at rock bottom, as natural gas prices in the US have soured and demand has reduced similarly.

However, as a result of COVID-19, the market closures, unscheduled holidays (i.e. China’s extended Lunar New Year holiday), quarantines and restrictions on people’s mobility and mandatory refinement could serve as a desired outcome for the defaulting party to challenge the valuation paid, deliveries and other notifications. 

Covid-19 has put excessive pressure on the economies of the world, but with Keynesian economics basics, i.e, government intervention during the recession, the financial markets are moving towards a more stable and improved condition. 

Recovery measures to be taken by the Australian economy:

While the impact of Covid-19 on the derivative market focuses on the if’s, but’s and why’s of the world commodities price fluctuations, there can be some easy measures which can help in the revival of the Australian economy. 

  • Promote Market transparency
    Improving the efficiency and transparency of derivatives market while keeping in mind feasible and appropriate standardisation of contract terms, inculcating electric trading platforms, clear communication and tailored risk and portfolio management. In the UK, London Metal Exchange suspended the open outcry trading to prevent the spread of the virus, thus, all orders will be made online, which also suggest that another way to revive the market during COVID-19 keeping in mind safety is closing the trading floors and inculcating online trading platforms. However, the transition will be smooth because the majority of the transactions are conducted online. For traders in other sectors, where it is dominated by the open outcry, particularly in the negotiation of complex options trades with multiple legs, the transition to all-electronic trading will require a very different approach to find the other side of the trade. On the participant end, it is recommended to examine their trading document to identify their current exposure under financial covenants and custom termination events and events of default. Moreover, if there is any concern about counterparty default, participants should review their policies and procedures for terminating ISDA agreements.
  • Expansion of collateral use to manage counterparty credit risks
    With Covid-19 and huge market fluctuations, it is suggested that appropriate collateralization is done, so that there is an alternative to risk management such as exposure limits, right to break clauses negotiation charges, etc.
  •  Flexible regulations
    As stated, COVID-19 is uncharted territory and to focus on getting out of this phase, many economies have putter natural tests and regimes to hold. For instance, the Bank of England has postponed its annual stress tests for the people nailed in the financial sector, as they should focus more on the on-hand topic, coronavirus outbreak. 
  • Prioritisation and resolving trade breaks
    Market participants at the end of the day should remain interconnected and coordinated as they face the enemy together. Moreover, to reduce the risk of cyber fraud and technological challenges, the Australian economy should take the US example, where the derivatives industry has unfitted from being an active participant in the Financial Services Information Sharing and Analysis Center. It helps in crisis communication between the US government and the financial services sector. 
  • Increase Australian influence in the International industry
    With being an active participant in International industry committees, Australian market participants can take opportunities and ensure market adequacy. 

History is our best teacher, with being the aid during the recession- the global crisis 2008 to being one of the deadliest things for the economies and businesses- Baring bank collapse in the ’90s, history shows us that if policies are not made with a clear head, derivatives trading in the wrong set of hands can be disastrous. 

Financial derivatives have the capacity of creating a financial crisis and being the silver lining during the recession. All it needs is a clear-headed leadership, political support and new thinking, which will push the Australian economy to new heights. But this depends on how the government reacts to the changes in liquidity and volatility. As of now the responses by the Australian regime have been quick and thorough, but more is yet to come. 

References
https://www.lexisnexis.co.uk/blog/banking-and-finance/the-impact-of-coronavirus-(covid-19)-on-otc-derivatives

https://www.apra.gov.au/sites/default/files/survey-of-the-otc-derivatives-market-in-australia-report.pdf

https://www.fia.org/articles/how-derivatives-industry-responding-covid-19

https://www.isda.org/2020/06/30/covid-19-and-the-impact-on-liquidity/

https://www.nortonrosefulbright.com/de-de/wissen/publications/0c7691d4/coronavirus-covid-19-issues-for-the-otc-derivatives-markets

The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ, our Partners and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.

Meet our authors:

Dahye Koo
Editor
Neharika Rastogi
Writer

Neharika is a MoM accounts and finance student with a flair for writing, numbers, and research all coming under one roof. She is interested in global trends, and believes in joining the qualitative, quantitative aspects with her researching skills.

Sarah Tu
Writer

Hello! My name is Sarah Tu and I am a third year B.Com student majoring in Finance and Management. I am a bright, inquisitive and straightforward Melbourne girl, always looking for opportunities to learn, communicate and share.

Matthew William
Writer