Exchange-Traded Derivative (ETD)

An exchange-traded derivative (ETD) is a derivative contract, usually a future or an option, whose terms are standardised by an exchange and which is traded on that exchange's platform and cleared through a central counterparty. Each contract has a fixed size, expiry date and, for options, set strike prices, so that buyers and sellers trade identical products. Investors, hedgers, banks and speculators use ETDs to gain or reduce exposure to interest rates, equity indices, currencies, commodities and other underlyings.

ETDs are the main alternative to over-the-counter derivatives, which are negotiated privately between two parties. Well-known exchanges include the Chicago Mercantile Exchange, Eurex and ICE. They are regulated in the United States mainly by the CFTC for futures and the SEC for securities options, and in the EU under MiFID II and EMIR.

A tailor-made suit fits one person perfectly but is hard to resell. A suit off the rack comes in standard sizes, so a shop can buy and sell thousands of them and anyone can compare prices. That makes them easier to trade, even if the fit is not perfect for everyone.

Exchange-traded derivatives are the off-the-rack version of financial contracts. The exchange decides the size, the dates and the rules, so everyone trades exactly the same thing on a public screen. A clearing house stands between buyer and seller and collects deposits from both each day, so neither has to worry much about whether the other will pay.

• Standardisation. Contract size, tick size, expiry cycle, settlement method and delivery terms are set by the exchange.
• Central clearing. Once a trade is matched, the clearing house becomes the buyer to every seller and the seller to every buyer, reducing counterparty risk.
• Margining. Participants post initial margin when opening positions and pay or receive variation margin daily, or more often, as prices move.
• Transparency. Prices and volumes are published, and trading usually takes place on a central order book.
• Access through members. End users trade through brokers and access clearing through a clearing member, known in US futures markets as a futures commission merchant.

A futures position's daily gain or loss is:

where $F_t$ and $F_{t-1}$ are today's and yesterday's settlement prices, $M$ is the contract multiplier and $N$ is the number of contracts, positive for a long position. A fund that buys 10 equity index futures with a multiplier of $50 at 5,000 index points has a notional exposure of 10 × $50 × 5,000 = $2.5 million. If the settlement price falls to 4,960, the fund pays (4,960 − 5,000) × 50 × 10 = −$20,000 in variation margin that evening. If its account falls below the maintenance level, it receives a margin call.

ETDs are used for hedging, for example by a corporate treasurer locking in a commodity price with a futures contract or a pension fund protecting equity holdings with index options; for adjusting portfolio exposure quickly and cheaply; for speculation; and for arbitrage between related markets. Banks use interest rate futures to manage the rate sensitivity of their books, and market makers provide liquidity across contract months and strikes. Options contracts on exchanges also offer standard ways to trade volatility.

Exchanges set position limits and accountability levels, monitor for manipulation and can impose emergency margins or trading halts. In the United States, futures exchanges are registered as designated contract markets with the CFTC, and their clearing houses as derivatives clearing organisations. In the EU, exchanges are regulated markets under MiFID II, commodity derivatives are subject to position limits, and EMIR requires ETD transactions to be reported to trade repositories, as described under trade repository reporting.

Standardisation and clearing make ETDs more liquid, transparent and lower in counterparty risk than bilateral OTC contracts, but less flexible: a hedger may face basis risk if contract dates or underlyings do not match its exposure exactly. OTC contracts can be tailored but carry more documentation, credit and liquidity risk, which is why post-2008 reforms pushed many standard OTC products into central clearing and onto trading platforms. Margin calls on ETDs can also create sudden liquidity needs during volatile markets.