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Standardization work in derivatives

How does Standardization work in derivatives contract markets?

Financial derivatives contracts are one of the most complex investable instruments. To trade them successfully, market participants should be familiar with each contract’s specific details and intricacies. Trading venues and exchanges have introduced unified guidelines and frameworks that set the standard for the quality, costs, and other detailed information for a particular derivative contract to make it easier. This guide explores the topic of standardization in derivative markets, what benefits it brings, and what it means for investors.

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What is the Standardization of Derivative Contracts?

Standardization of derivative contracts streamlines trade facilitation or financial transaction execution through a framework of agreements. Alternatively, it lists the detailed processes needed to ensure the consistent quality of a particular financial offering or transaction.

It covers all market participants in a transaction, including investors, fund managers, brokers, and more. All relevant parties must adhere to the standardization policies and guidelines. Doing so helps ensure that the adequate quality of the particular instrument is maintained.

To put it simply, the standardization of derivative contracts is a uniform set of guidelines. All parties accept these guidelines to ease the way they interact with each other. For example, with derivative contracts, these guidelines might include the number of units each contract covers, how we determine the price when we can trade them, delivery options, and more.

Standardization applies to all trading activities, including buying and selling stocks, commodities, futures, options, and more. With stock trading, the standardization practices are much more straightforward. Meanwhile, derivative contracts are essential and sensibly more complex due to the specifics of the traded instruments and their settlement.

What is the Benefit of Standardization?

Thanks to standardization, exchanges can ensure that a product offering is consistent with other equivalent items in the same class. Alternatively, it guarantees that the derivatives contract will always have the same characteristics, no matter whether you buy it today or in a month.

Aside from maintaining quality consistency, the standardization of derivatives contracts also ensures greater liquidity, trade execution efficiency, and cost reduction.

Besides, it also brings clarity to the way we conduct transactions. That way, each party related to a particular transaction knows what to expect from it.

In a nutshell, standardization introduces pre-set parameters within the derivatives market that determine the particular contract’s size, delivery dates, price, and other characteristics.

Examples of Standardized Derivatives

Standardized derivatives are also known as exchange-traded derivatives (EDT). The most common standardized derivative contracts are futures and options.

The role of standardization in these asset classes is to unify and systematize the way they are offered to the market.

Some of the most actively traded standardized derivatives include:

  • S&P 500 E-Mini (ES) futures contract traded on CME
  • Crude Oil (CL) futures contract traded on NYMEX
  • Eurodollar (ED) futures contract traded on CME
  • Corn (ZC) futures contract traded on CBOT
  • Soybeans (ZS) futures contract traded on CBOT
  • Henry Hub Natural Gas (NG) futures contract traded on NYMEX

The options contracts on the particular commodities also rank among the most traded in the respective asset class.

However, futures and options aren’t the only standardized derivatives. Derivatives of stocks, indexes, real estate, interest rates, and other instruments on public exchanges are also subject to this process.

Over-The-Counter vs. Exchange-Traded Derivatives

As a rule of thumb, all exchange-traded derivatives are standardized. Over-the-counter (OTC) derivatives, on the other hand, aren’t.

Instruments traded on public markets should adhere to the standardization guides of the particular exchange. Meanwhile, OTC derivatives aren’t subject to strictly defined standardization rules and can be customized.

This characteristic is also what defines the differences between both groups. Due to their standardized nature, ETDs enjoy higher liquidity. Furthermore, regulators like the Securities and Exchange Commission oversee the assets we trade on markets like the Chicago Board Options Exchange (CBOE), the Intercontinental Exchange (ICE), or the New York Mercantile Exchange (NYMEX). Another benefit is that clearinghouses (i.e., the CFTC) guarantee them. This vote of confidence means they significantly lower the associated risks for the participating investors.

Another distinguishing factor is that standardized derivatives are suited for all types of market participants. The list ranges from retail investors to institutions like pension funds, hedge funds, investment managers, and more.

How do OTC derivatives work?

By contrast, over-the-counter derivatives are much more complex, making it easy to lost track of the contract’s details. While the lack of standardization makes OTC assets more flexible and suitable for personalization, it also introduces more aggressiveness and complexity into the market, which isn’t exactly the best environment for mom-and-pop investors. Even if they wanted, retail and small-scale market participants would struggle to trade on the OTC market. The market itself heavily leans towards institutional investors.

The primary users of the OTC derivatives market are several large-scale investors (whales) who trade there to avoid destabilizing the public market with their big trades or simply to negotiate better terms. Although the OTC trades usually have massive individual volumes, they aren’t frequent. The trading activity on the unregulated markets is much more infrequent, making them less liquid. Many instruments don’t even trade daily.

How are Futures Contracts Standardized?

Let’s take the CME, for example. The exchange has standardized terms and specifications for each futures contract it lists and offers for trading. These specifications include a contract unit, a price quotation, trading hours, an expiration date, settlement procedures, lot size, quality, and other essential details.

Furthermore, exchanges also have guidelines that specifically state the underlying instruments they can use to create derivative contracts.

The idea of standardization for futures contracts is to make it easier for investors to get familiar with everything they should know about the instruments they are interested in.

Let’s take a look at what the standardization principles mean for futures contracts size, for example. Thanks to the defined guidelines, each contract is of a reasonable size that small investors can afford.

The size of a standardized futures contract depends on the instrument it covers. For example, with corn futures (ZC), a single futures contract unit equals 5,000 bushels. Meanwhile, in Eurodollar futures (GE), one contract buys you a $2,500 x Contract IMM Index. Finally, oil futures (CL), a single contract’s size, is 10,000 barrels. And so on.

How are Options Contracts Standardized?

Options contracts are standardized according to the specific guidance of the exchange they are trading at. The standardization specifics depend on the type of underlying instrument. Let’s take a corn options contract from the CME, for example. The standardization will cover contract specifics like the base unit, minimum price fluctuation, trading hours, listed contracts, exercise style, settlement method, and more.

When it comes to options contracts, you should know that there are all types of instruments you can trade. The standardization specifics depend on the market that lists them. For example, there are equity options, bond options, index options, currency options, interest rate options, options on futures, and even options on the weather forecast.

Now, let’s look at an example of how standardization covers contract size on equity options. Under the conventional standardization rules for options contracts on stocks, a single contract usually represents 100 shares of the particular company. The investor has to pay a premium fee for each contract he trades.

Let’s say you are willing to buy an options contract with a premium of $0.5 per contract. In that case, a single option contract would cost $0.5 x 100 shares = $50.

Other Standardized Derivatives

The most popular standardized derivative aside from options and futures is swaps. Swaps are contracts that allow the exchange of cash flows between two parties. The parties exchange the respective cash flow of their financial instruments for the cash flow of the other side when the terms suit their investment strategy better.

This type of deal aims to allow investors to ensure the exchange of a stream of cash flows that they are interested in against another stream that they don’t want to hold any longer.

There are different types of swaps, including interest rate swaps, currency swaps, and commodity swaps. Some markets also allow for the exchange of bond swaps and futures swaps.

The swaps standardization defines various contract specifics, including contract unit, trading hours, minimum price floatation, settlement procedures, delivery procedure, and more. These parameters clarify the exchange of cash flows, making the swap trading procedure much more transparent and less risky.

Final Thoughts

Standardization is an excellent mechanism to help market participants navigate the derivatives market better. It allows them to enjoy more liquidity and transparency when trading. Thanks to the market-pricing information, investors can better predict the outcome of their positions. Consequently, they can build more resilient risk management strategies. Standardization also helps exchanges ensure a healthy market environment that is equally welcoming to retail and large-scale investors.

On the other hand, OTC traded derivatives can be negotiated and customized to fit the needs of each side participating in the transaction. However, OTC markets are riskier and usually available to investors with substantial capital. That is why, if you are a beginner investor interested in derivatives trading, it is advisable to stick to the most liquid exchange-traded instruments where standardization will protect your interests.