THE STRUCTURE OF DERIVATIVE MARKETS

Having an understanding of equity, fixed-income, and currency markets is extremely beneficial—indeed, quite necessary—in understanding derivatives. One could hardly consider the wisdom of using derivatives on a share of stock if one did not understand the equity markets reasonably well. As you likely know, equities trade on organized exchanges as well as in over-the-counter (OTC) markets. These exchange-traded equity markets—such as the Deutsche Börse, the Tokyo Stock Exchange, and the New York Stock Exchange and its Eurex affiliate—are formal organizational structures that bring buyers and sellers together through market makers, or dealers, to facilitate transactions. Exchanges have formal rule structures and are required to comply with all securities laws.

OTC securities markets operate in much the same manner, with similar rules, regulations, and organizational structures. At one time, the major difference between OTC and exchange markets for securities was that the latter brought buyers and sellers together in a physical location, whereas the former facilitated trading strictly in an electronic manner. Today, these distinctions are blurred because many organized securities exchanges have gone completely to electronic systems. Moreover, OTC securities markets can be formally organized structures, such as NASDAQ, or can merely refer to informal networks of parties who buy and sell with each other, such as the corporate and government bond markets in the United States.

The derivatives world also comprises organized exchanges and OTC markets. Although the derivatives world is also moving toward less distinction between these markets, there are clear differences that are important to understand.