5. Governance Practices and Regulations for Derivative Products in Emerging Markets in the Wake of the COVID-19 Pandemic and the Subprime Global Financial Meltdown

Derivative securities derive their value from their connected underlying assets; and are traded on organized exchanges and over-the-counter (OTC) markets. Nevertheless, organized exchanges have significantly grown; however, OTC derivatives still account for a large portion of the total market value of derivative products. In essence, there are two major classifications of derivative products, depending on whether the client has the right (options contracts) or the obligation (forwards, futures, and swap contracts).

In line with Das (2010): ‘Derivatives are used to speculate, manufacture exotic risk cocktails, keep dealings off-balance sheet and out-of-sight, increase leverage and arbitrage regulatory or tax rules. The reality that industry participants will not acknowledge is that hedging and risk management is secondary to the other uses’ (Das 2010). ‘For companies, the ability to use derivatives trading to supplement traditional earnings, which are under increased pressure, is irresistible. For institutional and retail investors, the use of derivatives to improve returns through leverage and access to different risks is now a vital part of the investment process’ (Das 2010).

For further discussion on liquidity risk and Liquidity-Adjusted Value-at-Risk (LVaR) literature using Al Janabi model, we can refer the readers to Madoroba and Kruger (2014) and Al Janabi (2011, 2012b, 2013, 2014) research papers. In their paper, Madoroba and Kruger (2014) review and compare ten liquidity risk VaR models, including Al Janabi model. In his research papers Al Janabi (2011, 2012b, 2013, 2014) present a robust and novel machine learning technique and optimization algorithms, which is based on Al Janabi model (Madoroba & Kruger 2014; Al Janabi 2008c), for the computational process of a closed-form parametric LVaR. Indeed, Al Janabi model and its related optimization algorithms can be used in machine learning processes for a direct computational process of market and asset liquidity trading risks, and within a multivariate context for multiple-assets portfolios. In addition, the robust Al Janabi model (Madoroba and Kruger 2014; Al Janabi 2008c) is quite simple to implement even by very large financial institutions with multiple assets and risk factors. For other relevant literature on liquidity risk, internal risk models, and portfolio selection one can refer as well to Asadi and Al Janabi (2020), Al Janabi (2020), Arreola-Hernandez and Al Janabi (2020), Grillini et al. (2019), Al Janabi et al. (2017), Al Janabi et al. (2019), Madoroba and Kruger (2014), Arreola-Hernandez et al. (2017), Arreola-Hernandez et al. (2015), among others.

Because of the “first-mover-effect”, derivative exchanges in emerging markets need to design innovative and competitive products combined with long-term-planning.

In the media of certain emerging markets, which are infamously recognized as illiquid standardized derivatives exchanges, there were some bragging press interviews with senior management regarding the development of new contracts on electricity, inflation and gasoline, etc. with the objective of competing with other very well recognized derivatives houses, such as, the Chicago Mercantile Exchange (CME). These self-delusion attempts must be examined carefully and compared with the experiences of other regional derivatives markets because of the “first-mover-effect”. In addition, it is important to emphasis that the trading of derivatives contracts on electricity is not an easy ride, as it requires considerable infrastructure to deal with this kind of contracts, such as pricing and valuation and regulations, etc. These contracts are notoriously known to have huge volatility (due to the different peak hours for electricity consumption during the day), let alone the peculiarity of electricity as an asset since it is generated instantaneously and cannot be stored like many commodities.

For further discussion on the development and implementation of derivatives securities in other emerging markets such as Chile, one can refer to Fernandez (2006).