Swiss Derivative Markets

Abstract

Volatility is the mother of derivatives, but there is debate about whether speculation or hedging is the legitimate father. A virtual explosion of derivative activity has occurred during the past 50 years, as prices have become more volatile, contributing to a growing demand for hedging and the possibility of earning speculative profits. Derivatives are central to today’s financial markets and have grown to eclipse, in notional value, both the international equity and bond markets. Switzerland’s financial sector has actively participated in developing this global market. The key to success has been an ability to offer valued products at competitive prices with highly efficient processes, combined with trusted commitments to protect client confidentiality and assurances of liquidity and solvency, especially during stressful financial periods.

Introduction

Volatility is the mother of derivatives, but there is debate about whether speculation or hedging is the legitimate father. Starting in the 1970s and extending more than two decades into the twenty-first century, derivative use, sophistication, and volume have grown significantly. Large, developed economies like the United States, the European Union, Japan, and the United Kingdom have nurtured their derivative markets, with financially adept countries such as Australia, Canada, and Switzerland doing the same. These seven participants rank among the largest and most innovative global providers of derivative instruments, controlling more than three quarters of its over-the-counter (OTC) turnover in 2022.¹

Derivatives are central to today’s financial markets and have grown to eclipse, in notional value, both the international equity and bond markets. A virtual explosion of derivative activity has occurred during the past 50 years, as exchange rates, interest rates, commodity prices, and credit ratings (private and government) have become more volatile, contributing to a growing demand for hedging and the possibility of earning speculative profits. Although derivative markets have come under scrutiny for abuses,² derivative instruments hold an important position in the financial industry due to their ability to shift risk from those who do not want it to those who do.

Switzerland’s financial sector (especially the banking sector and asset managers) has actively participated in developing global derivative markets. Since it created the world’s first completely automated derivatives exchange (SOFFEX) in 1988, the pace of activity accelerated, with a rapid-fire succession of mergers, acquisitions, and new product introductions. The key to success has been offering valued products at competitive prices with highly efficient processes. These attributes have been combined with trusted commitments to protect client confidentiality and assurances of liquidity and solvency, especially during stressful financial periods. This chapter describes Switzerland’s derivative markets and its financial industry’s efforts to offer a wide array of competitive derivative products on one of the most advanced trading platforms in the world.

Evolution of the Derivative Markets

Derivative contracts have been in use for more than two millennia. There is evidence, as early as 2000 B.C., that they were used in trades between India and the Arab Gulf.³ In his book Politics, Aristotle tells the story of Thales, who contracted the future use of oil presses in the towns of Miletus and Chios after predicting a good olive harvest the following year (apparently based on his astrological skills).⁴ With few competitors to bid against him, Thales secured the presses at meager prices, and, when the abundant oil-making harvest arrived, he was able to charge a handsome price for the presses he controlled.⁵

Derivatives are creative byproducts of volatility. Starting in the 1970s and extending into the twenty-first century, their usage, sophistication, and volume have grown significantly. Europe, in general, and Switzerland, in particular, have nurtured their derivative markets. Growth in European derivative markets has paralleled the United States, albeit with a lag. During the 1970s, large derivative exchanges existed almost exclusively in the United States, but Europe followed in step during the 1980s and 1990s as trends in financial deregulation spread globally. The twenty-first century has witnessed a rise in Asian derivative markets.

From the beginning, state-of-the-art communication systems were an inseparable component of US, European, and Asian derivative exchanges. Fully electronic transaction platforms revolutionized trading behavior and strategies, thereby setting the pace for other sectors of the financial markets.

Derivative markets have had their share of problems. Many observers trace the roots of OTC market difficulties to the U.S. Commodity Futures Modernization Act of 2000 (CFMA), which recast the competitive derivative landscape, both in the United States and internationally, enabling trading practices that fueled speculation. Because the United States was such a dominant and established international player, its rules, regulations, and procedures affected the exchanges of all nations wishing to compete in these markets. As a result, the laissez-faire attitude of US regulators, based on a free-market ideology, spilled into other countries.

The CFMA exempted eligible users⁶ of OTC derivatives from trading and clearing regulations imposed on exchange-traded products. By disconnecting OTC markets from the familiar moorings of exchange-traded markets and reporting requirements and severing them from most federal and state regulations, the CFMA encouraged growth in the OTC derivative markets and promoted the abandonment of sensible exposure-to-reserve ratios.⁷ Warning signs were abundant. In 2008, U.S. Securities and Exchange (SEC) Director Christopher Cox called the derivative market a “regulatory black hole.”⁸

The US financial crisis from 2007 to 2009 caused the US Congress, on July 21, 2010, to pass the Dodd-Frank Wall Street Reform and Consumer Protection Act.⁹ This far-reaching Act effectively touched every major part of the US OTC derivative market to increase transparency, improve efficiency, reduce counterparty risk, and diminish systemic threats to the US financial system. Title VII of the Act (the Wall Street Transparency and Accountability Act of 2010)¹⁰ established a new framework for regulating and supervising OTC derivatives.

To improve derivative transparency and safety, the Act focused on clearing, trading, capital and margining requirements, segregation of customer margin accounts, and end-user exemptions.¹¹ It also addressed position and activity limits, ownership and corporate governance of derivative clearing organizations, market structure, swap execution facilities, and new business standards.¹² Finally, the Act addressed reporting, recordkeeping, confirmations, documentation, regulation, and regulatory coordination.¹³ One of the easiest ways to accomplish these goals was to require the execution of derivative transactions on trading platforms (e.g., swap execution and clearing facilities). With some exceptions, such as end-user hedging, all approved (clearable) derivative transactions were required to be cleared and executed on such platforms.¹⁴

Regulatory responsibilities for swaps were separated and assigned to the Commodity Futures Trading Commission (CFTC); securities-based swaps were delegated to the Securities and Exchange Commission (SEC).¹⁵ Cross-agency coordination and cooperation were mandated. Strict rules were imposed to guarantee that net and gross positions were transparent. Limitations and prohibitions were placed on the activities and functions of insured depository institutions and systemically significant entities. The Volcker Rule banned proprietary trading by insured banks and their affiliates. The Collins Amendment set minimum capital requirements, and the Lincoln Provision required banks to push out unauthorized derivative transactions into independently capitalized companies.

Because derivative markets are so intimately and inextricably intertwined with their corresponding underlying markets, meaningful reform in the United States could only be accomplished if it were done at both the derivative and underlying levels. Similarly, because financial markets are so globally interconnected, the success of US reforms depended on equally significant reforms internationally. Without such cooperation, the derivative business would quickly shift to markets of least resistance, which could prompt an undesired race to the bottom as countries compete to have the least restrictive regulatory environment.

US rules governing OTC derivatives directly affected domestic US financial markets and had ripple effects worldwide. To the extent these rules increase costs, they could have dampened derivative market growth and reduced bank profits. Higher costs could have caused US financial institutions to lose competitive advantages to foreign markets. Less liquidity may have caused many bespoken (OTC) derivatives to become less available, harder to execute, and higher priced. Clearinghouses may have been forced to clear transactions for which no adequate risk mitigation alternatives existed. Confusion was sure to result as new rules were promulgated and their inconsistencies and consequences came to light, but this is a natural part of the maturing process for any organic entity. Due to Dodd-Frank Act reforms, major derivative providers, like Switzerland, reassessed their domestic markets.

OTC Derivatives Versus Exchange-Traded

Derivative trading occurs on OTC markets (i.e., between counterparties with customized products that fit their specific needs) and exchanges with standardized products.

OTC-Traded Derivatives

Market participants use the OTC market to trade customized, bilateral derivative contracts. In contrast to standardized exchange-traded markets, the OTC markets offer users the ability to customize product features, allowing them to address specific hedging or speculative needs. By tailoring derivative contracts, users can avoid potentially costly risks caused by mismatches between the size, maturity, and basis between underlying positions and their hedges. OTC derivatives may lack critical benefits of exchange-traded derivatives, such as liquidity, price transparency, efficient price discovery, and low counterparty risk. Nevertheless, customization has fueled their rapid growth and enabled them to dwarf the size of exchange-traded derivatives.

The size of OTC markets can be deceiving because closed trades are typically made with counterparties different from the original ones. As a result, the market’s size increases every time a position is reversed before maturity. These reversals (purchases and sales) cause the gross size of the OTC market to rise without the net market size and risk changing. Problems can arise with counterparty risk. The more OTC contracts traded before maturity, the more distant the original counterparties are from one another. A weak one who defaults anywhere along the purchase-and-sale chain could cause this OTC house of cards to fall. Taken to an extreme, these failures could cause systemic problems, as happened in 2008 when credit default losses led to the collapse of Lehman Brothers and resulted in severe financial difficulties in the United States. Exchanges reduce or eliminate this double counting by netting transactions.

Among the significant OTC participants are:

• 1. Investors interested in margin loans to leverage shareholdings;

• 2. Banks, asset managers, and large corporations seeking to hedge existing exposures;

• 3. Investors looking to acquire shareholdings in companies;

• 4. Investors searching for tailor-made exposures through structured products;

• 5. Investors pursuing yield enhancement, and

• 6. Investors on the hunt for exposure to markets and otherwise unavailable products.

Standardized Exchange-Traded Derivatives

Exchange-traded derivatives are standardized contracts transacted on globally linked electronic platforms. The exchange functions as a middleman between buyers and sellers, offering liquidity and anonymity to customers. Being well capitalized, they reduce counterparty risks present in the OTC markets.

Exchange-traded derivatives enjoy high price transparency and efficiency levels, especially for clearing, netting, and margin collection and maintenance. Generally, the number of contracts traded daily is large enough to allow all but the largest derivative traders the opportunity to quickly buy or sell positions without affecting their market prices. Customers benefit by efficiently liquidating unwanted holdings or acquiring desired ones.

Nevertheless, there are times when contracts can be relatively illiquid, such as when exceptionally large positions need to be traded. In these cases, an institutional investor may directly engage market makers to agree and finalize transactions before informing the general public (i.e., off-exchange trades are negotiated and agreed to and afterward blocked on the exchange). For substantial trades, notification to the exchange may be delayed until after the market closes, allowing investors to protect their information temporarily. In doing so, they can take advantage of an exchange’s standardized contracts, margining, and clearing. Investors also gain flexibility by agreeing to large, off-exchange trades directly with market makers, who provide liquidity to the system.

To minimize counterparty and systemic credit risks, exchanges require customers to deposit cash margins, which are marked to market daily. Exchanges further mitigate risk by netting and efficiently clearing transactions. One of the striking features of the 2007-to-2009 financial crisis was that derivative exchanges survived the disaster, despite plunging housing and stock prices. None failed, and trading took place in an orderly manner. Generally, the systems regulating these exchange-traded derivatives worked as they should have, and trading activity functioned effectively. Trading rules and regulations were followed and enforced, and, as a result, trading was essentially free from price manipulation, fraud, and abuses.¹⁶

Global OTC Derivative Markets

Relative to almost any financial measure, derivative markets are enormous. Table 10.1 shows the two ways to gage the size of global OTC derivatives for interest rate, foreign exchange, credit default swap, equity-linked, and commodity derivative contracts. At the end of 2021, the notional value and gross market value of these outstanding OTC derivative contracts were estimated at approximately USD 1,207 trillion and USD 25 trillion, respectively.¹⁷ Derivatives backed by interest-earning securities comprised the lion’s share of the total market (i.e., 70.1%).

Table 10.1 Notional and Gross Value of Global Derivative Transactions by Product Group: 2020 & 2021

Table 10.2 shows the 2020 to 2022 figures for global exchange-traded futures and options, which are markets that pale compared to the OTC derivative markets (compare Tables 10.1 and 10.2). Exchange-traded interest rate derivatives dominated relative to foreign exchange derivatives.

Table 10.2 Exchange-Traded Futures and Options: 2020 to 2022

Switzerland's Derivative Market Development

Forward transactions and premium trades were a part of Swiss financial markets long before the 1970s when derivatives burst onto the world economic stage. Nevertheless, Swiss derivative development accelerated after the collapse of the Bretton Woods exchange rate system in 1971 and the subsequent failure of the Smithsonian Agreement in 1973. To remain competitive in the international financial markets, Switzerland needed a derivative counterpart to its equity, debt, and currency markets.

Swiss Options and Financial Futures Exchange (SOFFEX)

During the early years of the derivative surge, Swiss derivative markets were fragmented, with multiple local exchanges vying for pieces of the action. Initially, Swiss exchanges traded derivatives using the open outcry method, having local market participants trade derivatives among themselves using hand signals to signify buy and sell orders and the agreed-upon price. This method put them at a competitive disadvantage in terms of volume and efficiency relative to rapidly computerizing exchanges. The writing was on the wall. To survive and thrive, the Swiss derivative markets needed a consolidated, efficient, automated, and state-of-the-art derivatives trading platform.

Behind the formidable growth of derivatives in Switzerland and worldwide was the evolution of trading platform technologies that permitted the transition from phone-based to web-based transactions. The ideal system would be accessible from anywhere and at any time, but convincing local exchanges to consolidate and completely change their mode of operation was problematic because it entailed losses of jobs, incomes, and power. Nevertheless, the advantages of creating an electronic exchange were significant enough to catch the imagination of a broad enough spectrum of Switzerland’s financial community to make the transition.

In 1988, the Swiss Options and Financial Futures Exchange (SOFFEX) was launched as the world’s first fully automated options and futures exchange. It renewed and reinvigorated Switzerland’s standing as one of the technological leaders in the financial community. Because financial markets are complex and interconnected, creating a fully electronic derivatives exchange was only possible with efficient equity and debt markets as a prerequisite.

In 1989, the Swiss Stock Exchange Association’s board officially decided to create a single, fully electronic, integrated financial exchange for Switzerland. Swiss legislation was changed to transition from local markets to a unified national exchange. A federal Swiss exchange law replaced cantonal legislation, thereby facilitating the closure of local floor-trading exchanges in Geneva, Basel, and Zurich. In their place, the SWX Swiss Exchange was created as the nation’s integrated marketplace for trading, clearing, and settling financial transactions. In September 2008, the SWX Swiss Exchange changed its name to SIX Swiss Exchange Ltd¹⁸ to promote the brand strategy of SIX Group (formerly Swiss Financial Market Services).

Scoach, SIX Structured Products, & Swiss Digital Exchange

The momentum of financial reform continued. In 1998, SOFFEX merged with Deutsche Börse (DTB)¹⁹ to form Eurex. This partnership proved to be a wise, business-savvy decision. It not only united the financial markets of two highly developed countries, but it also merged financial entities willing and able to abandon old ways and positively transform their trading platforms.

By 2007, electronic broking systems played a crucial role in global derivative markets, and both Switzerland and Germany were recognized for their advanced technological prowess. Not surprisingly, electronic transactions in these two countries were among the highest in the world.

On January 1, 2007, SWX Swiss Exchange and DTB started and managed an exchange for structured products called Scoach, with operations in Eschborn, Germany (near Frankfurt), for euro-denominated contracts, and in Zurich, for Swiss franc-denominated ones. In February 2013, Scoach was split into Scoach Europa AG, wholly owned by DTB, and Scoach Schweiz AG, a wholly owned subsidiary of the SIX Swiss Exchange. Scoach Schweiz AG was renamed SIX Structured Products in November 2013.

In 2019, SIX Structured Products launched the SIX Digital Exchange (SDX), a FINMA-licensed and regulated financial market infrastructure (FMI), offering a digital marketplace for security trading, settlement, and custody.²⁰ As part of its strategy, the SDX has collaborated with technologically advanced companies that can bring value to the Swiss financial value chain. From the beginning, the SDX was responsible for executing the SIX Group's digital asset and blockchain strategies, releasing a blockchain platform the year it was created. On it, digital security tokens that include equities, bonds, funds, and commodities can be traded. The SDX chose R3’s Corda, an open-source distributed-ledger platform developer, to build its blockchain platform. The SDX’s efforts were expanded in May 2019 when the SIX Group confirmed the development of its own stablecoin that would be pegged to the Swiss franc and traded on the SDX.²¹

On its digital platform, the SDX offers FQX’s standardized, short-term debt instruments called eNotes™.²² Single eNotes are stored as non-fungible tokens (NFTs) on the SDX’s blockchain. Issuers can obtain financing by issuing multiple eNotes. An eNote can be used to pay a specific amount to another party or for future purchases, much like a forward contract. The SDX-FQX collaboration increases the liquidity and efficiency of Switzerland's financial markets and globalizes Switzerland's debt market infrastructures.

SWISS FRANC-DENOMINATED DERIVATIVE MARKETS

While dollars and euros are the dominant currencies in which derivative trades are transacted, the Swiss franc remains one of the most important currencies in the world, along with the Japanese yen and British pound.

Swiss Franc OTC Foreign Exchange and Interest Rate Derivatives

Figure 10.1 shows the growth of OTC-traded Swiss franc-denominated foreign exchange and interest rate derivatives.

Fig. 10.1

*Figures for 2019 cannot be compared to previous years due to a change in the statistical collection. See footnote 23. Source Bank for International Settlements, Turnover in Foreign Exchange and Derivatives Markets in Switzerland—BIS Triennial Survey in 2019, https://data.snb.ch/en/topics/texts/doc/ddum_2019#umdev (Accessed on August 26, 2022). Bank for International Settlements, Triennial Survey Foreign Exchange and Over-the-Counter (OTC) Derivatives Markets in 2022 (Preliminary results) https://www.bis.org/statistics/rpfx22.htm (Accessed on November 3, 2022. Full publications are available on the BIS website free of charge: www.bis.org

Daily Swiss Franc OTC Foreign Exchange and Interest Rate Derivatives: 1995–2022

• Between 1995 and 2010, they grew by 257%, from USD 91 billion to USD 324 billion, which was a 29% compound annual growth rate;

• From 2010 to 2016, these two derivative classes fell by approximately 49% (i.e., at a compound annual rate of decline equal to almost 11%); and

• From 2019 to 2022, OTC-traded Swiss franc-denominated foreign exchange and interest rate derivatives grew by almost 30%, a compound annual growth rate of about 9%.²³

Table 10.3 shows the nominal size of each Swiss franc derivative product group and its growth rate from 1995 to 2022.²⁴ In 2022, interest rate swaps dominated the field of derivative alternatives, accounting for 79% of the market, followed distantly by outright forwards (15%), and foreign exchange options (5%). Together, they were responsible for more than 99% of Switzerland's foreign exchange and interest rate derivatives. Growth rates varied during the 27 years, with foreign exchange swaps, outright forwards, foreign exchange options, and currency swaps growing between 6 and 8% per year. Volume in forward rate agreements rose by 0.4% per year, and options fell by 0.2% per year, respectively.

Table 10.3 Daily OTC Swiss Franc Foreign Exchange and Interest Rate Derivatives by Product: 1995–2022

In 2022, 76% of all Swiss franc-denominated foreign exchange and interest rate derivatives were among financial institutions in different countries. Local financial institutions accounted for 21%, and both local non-financial customers and cross-border non-financial customers accounted for slightly more than 1% each.²⁵ For currency pairs, daily turnover in the EUR/USD and CHF/USD contracts accounted for 29 and 23%, respectively, with contracts for EUR/CHF (8%) and USD/JPY (7%) following behind.²⁶

Swiss Franc Exchange-Traded Futures Market

Futures markets in Swiss franc-denominated foreign exchange and interest rate derivatives were a small fraction of all OTC transactions. In 2022, the Swiss franc-denominated open interest for exchange-traded funds was approximately 0.2% of the total global size, and the daily average turnover for Swiss franc interest rate and foreign exchange derivatives was close to zero percent (see Table 10.4).²⁷

Table 10.4 Swiss Franc Exchange-Traded Futures and Options: 2020, 2021, and 2022

Swiss SIX Exchange’s Structured Products

The SIX Exchange provides a platform to trade warrants and structured products from various issuers. Structured products are combinations of cash investments and derivatives.²⁸ Examples of cash investments are bonds and shares; options, forwards, and swap contracts are derivative products.²⁹ Once combined, structured products are sold as stand-alone securities and provide investors with opportunities to invest in assets with payoff profiles that may not have been available previously.

A significant benefit of structured products is their ability to create tailor-made payoff profiles that can be used to hedge, extract yields, or speculate. Furthermore, they can allow participation in markets and products which otherwise might not be accessible or difficult to find. As we will discover later in this chapter (see Table 10.6), “yield enhancement” is the principal goal of most structured-product investors on Swiss exchanges. Highly customized structured products can lack liquidity because the pool of potential investors shrinks the more esoteric a product becomes. For hedgers that settle at maturity (i.e., those using a buy-and-hold strategy), liquidity is not a significant concern.

SIX’s structured products are mainly denominated in US dollars, euros, and Swiss francs. Publication of real-time prices and the SIX’s guarantee of liquidity³⁰ enhances the ability to trade them at any time (24/7). Since March 2015, Issuers on the SIX Exchange have been required to publish all the fees that enter into the issue price, including partner payments.³¹

Professional exchange participants on the SIX are security traders and foreign security exchange members authorized to perform trades on behalf of their customers, with access to the reference market for Swiss securities.³² They include banks, collective investment schemes, asset managers for collective investment schemes, fund management companies, holding companies of financial or insurance groups and conglomerates, insurance and reinsurance companies, investment foundations, pension funds, and securities dealers. Becoming a trading participant is a two-step process involving business and operation setups. Successful applicants must comply with Switzerland's Stock Exchange Act, be authorized securities traders or members of a foreign securities exchange, comply with organizational, accounting, and auditing standards, and follow the rules and directions established by the Swiss Stock Exchange.

Because the issuers of underlying bonds or other debt obligations are liable for repaying their commitments, these products’ risks are based on the issuers’ creditworthiness. Virtually all structured products are unsecured debts, which means they lack protection in cases of issuer default or insolvency.³³ Perceptions of creditworthiness can be obtained from credit spreads and credit ratings, which are made available on the SIX’s website, as are the credit ratings of its members.³⁴ In Switzerland, these financial instruments are not considered collective investments and, therefore, are not protected by Switzerland's Collective Investment Schemes Act (CISA).³⁵ For these reasons, investors must beware of the implied credit (counterparty) risk involved in structured product transactions and understand the risks they face when an issuer has difficulty meeting payments. The SIX has created rules and safety nets to mitigate these risks, such as margin deposits and netting.

The SIX Swiss Exchange is responsible for admitting structured products that trade on the SIX platform. Once approved, SIX Exchange Regulation (SRG) is responsible for customer protection by regulating Swiss issuers and their securities. The SRG is an affiliate of the SIX Swiss Exchange, ensuring that structured products are transparent, with clear definitions and terms.

The Swiss Structured Products Association (SSPA) has 40 members, who act as issuers, buy side, markets, and partners. Together, they account for 95% of Switzerland's structured products market.³⁶

Domestic banks and foreign financial institutions participate on the SIX. They include:

• Big banks: UBS and Credit Suisse,

• Cantonal banks: Zürcher Kantonalbank, Banque Cantonale Vaudoise, Basler Kantonalbank, and Luzerner Kantonalbank, and

• Other Swiss banks, such as Bank Julius Bär, Bank J. Safra Sarasin, Bank Vontobel, VFP Dubai, and Raiffeisenbanken.

Among the foreign financial institutions that participate on the SIX are Goldman Sachs, J.P. Morgan, and Société Générale.

The Swiss market for structured products has been growing rapidly. In 2020 and 2021, turnover reached CHF 368 billion and CHF 337 billion, respectively, with the most popular asset classes being equity (approximately 56%), foreign exchange (roughly 24%), and fixed-income products (about 10%). Almost two-thirds of the turnover was in non-listed products. Euros and US dollars, each with approximately 38%, and Swiss francs (12%) accounted for 88% of total turnover.³⁷

In Switzerland, only Swiss banks, insurers, stockbrokers, and foreign financial institutions supervised by Swiss authorities may engage in public sales, issues, guarantees, or distributions of structured products. They are further regulated by requiring each of these foreign institutions to have, among other thgs, at least one branch in Switzerland.³⁸

Table 10.5 lists the major categories of structured products on the SIX Exchange. In 2022, it offered 36,000 structured products arranged in five categories: (1) Capital protection, (2) Yield enhancement, (3) Participation, (4) Leverage, and (5) Investment products with reference issuers. Their functions are to:

• Protect capital,

• Optimize yields,

• Participate in the markets as one who would own the underlying, and

• Take on credit risk.

Table 10.5 SIX Structured Product Groups and ProductsFootnote

The source of Table 10.5 is the SSPA. Some professional traders and asset managers might be critical of it, arguing that a few categories seem redundant. For example, Reverse Convertibles with or without Barriers are similar in investment goals. Some products could be included, such as Range Accrual Notes and more bespoke products, as well as autocallable and issuer-callable overlays, which are among the most popular.

OTC equity derivatives are neither taxable for purposes of Swiss Stamp Tax nor do they trigger a withholding tax under the Swiss Withholding Tax Act.⁴⁰

In 2020 and 2021, yield enhancement was the most popular product traded on the SIX, followed distantly by leverage, participation, and capital protection (see Table 10.6).⁴¹

Table 10.6 Customer Demand for SIX Product Classes: 2020 and 2021

Equity products have been responsible for more than half of the SIX’s structured products activity, with foreign exchange transactions roughly half the size of equity trades and fixed income/credit trades nearly half of foreign exchange transactions (see Table 10.7 for 2020 and 2021 comparisons).

Table 10.7 Demand for Structured Product Groups: 2020 and 2021

U.S. dollar-denominated products were most popular, followed closely by euros, with Swiss franc-denominated transactions accounting for about 12% of the total (see Table 10.8 for 2020 and 2021 figures).

Table 10.8 Currency Structure of SIX Structured Product Transactions: 2020 and 2021

SIX Trade Repository AG and Regis-TR S.A

On April 3, 2017, FINMA authorized Switzerland’s first Swiss trade repository, the SIX Trade Repository AG. It also recognized Regis-TR S.A as Switzerland's first foreign trade repository.⁴² Authorization of these repositories obligates Swiss derivative participants (financial and non-financial) to report their transactions to a FINMA-authorized trade repository. Only one of the counterparties or a chosen third party is required to report the details of open and new transactions. The report must be filed no later than one day after the transaction has been concluded, amended, or terminated. Among the details included in the report are counterparty identities and contract details, such as the transaction type, maturity, notional amount, settlement date, and currency denomination. Independent of the trade repository report, Swiss securities dealers and other exchange members must report their derivative or structured-product transactions to the exchange on which the underlying securities are listed. Swiss security firms and other SIX Exchange members must also report their derivative transactions to the exchange on which the underlying asset is admitted, regardless of whether it is traded on or off that exchange.

Switzerland's OTC Laws and Regulators

The organization and operation of Swiss financial market infrastructures and the conduct of financial market participants in securities and derivatives are based on the Federal Act on Financial Market Infrastructures and Market Conduct in Securities and Derivatives Trading (FinMIA, June 19, 2015).⁴³ The FinMIA entered into force on January 1, 2016⁴⁴ and applied to derivative transactions between Swiss counterparties and between Swiss and foreign counterparties. Administration of these rules is the responsibility of the FINMA, the Swiss National Bank (SNB), and the Federal Department of Finance. The FinMIA delegates regulatory powers to Switzerland’s Federal Council and the FINMA. The SNB has supervisory authority in cases where systemic threats to the Swiss financial system arise. Therefore, it imposes requirements on OTC counterparties for reporting, clearing, and risk mitigation.⁴⁵

The FinMIA prohibits insider trading and market manipulation.⁴⁶ Supporting it are ordinances offered as guidelines by the Federal Council, FINMA, and SBA. Three particular ordinances are most important. They are the following:

• 1. Federal Council-issued Ordinance on Financial Market Infrastructures and Market Conduct in Securities and Derivatives Trading (Financial Market Infrastructure Ordinance, FinMIO),

• 2. FINMA-issued Ordinance of the Swiss Financial Market Supervisory Authority on Financial Market Infrastructures and Market Conduct in Securities and Derivatives Trading (FINMA Financial Market Infrastructures Ordinance, FinMIO-FINMA), and

• 3. SNB’s 2016-issued amendment to the National Bank Ordinance (Ordinance to the Federal Act on the Swiss National Bank, NBO).⁴⁷

The guidelines in these ordinances are general, such as:

• Clarifying the processes for provisional recognition of the European Market Infrastructure Regulation (EMIR);

• Informing participants of collateral exchange regulations;

• Explaining counterparty reporting requirements;

• Aligning Switzerland's obligation to exchange collateral with EU provisions, which required revising the FinMIO;

• Identifying OTC derivative categories that should be subject to clearing obligations, selected mainly for standardized interest-rate and credit derivatives, which meant entering into discussions over revising the FinMIO-FINMA;

• Requiring mandatory clearing for standardized OTC-traded credit derivatives and interest-rate derivatives denominated in euros, pounds, yen, and U.S. dollars, and

• Making FINMA-appointed auditors responsible for reporting to FINMA any breaches in FinMIA, with failures to comply elevated (possibly) to the FDF, which has the authority to initiate administrative criminal proceedings, with fines as high as CHF 100,000.

EUREX

Eurex is an abbreviation for European Exchange.

Eurex Exchange is Europe’s largest derivatives marketplace, with a product suite comprising actively traded contracts. Among the financial derivatives offered by EUREX are the following.

• 1. Equity options, futures, total return swaps, security spread futures, and stock tracking futures,

• 2. Equity index derivatives,

• 3. Short-term, medium-term, and long-term interest rate futures and options,

• 4. Foreign exchange futures, options on futures, and rolling spot futures,

• 5. Volatility futures and options,

• 6. Total return futures on indices (e.g., banks, dividends, collateral, and large index),

• 7. Futures and options on MSCI indices for developed and emerging markets, and

• 8. Equity index futures and options on ESG underlyings.⁴⁸

At the end of 2022, cryptocurrency derivatives were expected soon.⁴⁹

Liquid trading in euro-denominated, equity-index, and Swiss franc-based derivatives takes place alongside markets for MSCI indices (often denominated in U.S. dollars), volatility, and dividends. Eurex also has a broad offering of single equity products, alternative asset classes, commodities, and debt securities.

Eurex was founded in 1998 as a partnership between Deutsche Börse AG (DTB) and the SIX Swiss Exchange. At that time, electronic trading systems were growing relative to the traditional open outcry systems. Eurex was one of the first exchanges to offer fully electronic trading to its users. Today, it is Europe’s largest futures and options market, primarily offering European-based derivatives.

Eurex is located in Eschborn, Germany (near Frankfurt), servicing dealers from more than 700 locations worldwide, with most activity online. It also provides clearing and contract settlements. The clearing is done through Eurex Clearing, which serves about 200 members in 19 countries.

In 2020 and 2021, the number of derivative products traded on Eurex equaled approximately 1.9 billion and 1.7 billion, respectively, falling by roughly 8%.⁵⁰ European equity index derivatives accounted for more than 56% and 47% of the market in 2020 and 2021, respectively.⁵¹ The notional outstanding volume of OTC Clearing was approximately EUR 16.6 trillion in 2020 and EUR 20.1 trillion in 2021, an increase of more than 20%, with interest rate swaps accounting for approximately 50%.⁵² Between these years, average daily cleared volumes grew from EUR 122 billion to EUR 133 billion, an increase of 9%.⁵³

Eurex Clearing

Eurex Clearing is incorporated in Germany as a licensed credit institution under the supervision of the BaFin, Germany’s Federal Financial Supervisory Authority, which acts under the nation’s Banking Act.⁵⁴ Eurex Clearing is the central counterparty (CCP) for all exchange-traded and OTC-traded transactions executed on Eurex. It is also an authorized clearing house under the European Market Infrastructure Regulation (EMIR), and in February 2016, the U.S. Commodity Futures Trading Commission (CFTC) granted Eurex clearing status as a Derivatives Clearing Organization for swaps related to entities located in the United States.⁵⁵

Eurex Clearing handles a broad range of listed and OTC transactions, including equities, bonds, energy transactions, and secured funding. It serves about 200 members in 19 countries, manages a collateral pool of around EUR 49 billion, and clears monthly trades worth approximately EUR 11 trillion. Eurex Clearing offers customers fully automated, straight-through, post-trade services specially designed for derivatives, cash equities, repo, and fixed-income transactions, including clearing bilaterally agreed on/off-exchange transactions.

As a CCP, Eurex Clearing stands between derivative buyers and sellers, providing customers anonymity in trading and settlement. It also provides security because the entire exchange would need to fail for their contracts to become worthless. Eurex Clearing increases efficiency by giving buyers direct access to derivatives and security financing transactions. Combining and netting the transactions of a large and diverse set of participants substantially reduces single counterparty and systemic risks, using cross-margining to conserve collateral. It also concentrates risk by pooling everything under the roof of a single institution. The consequences of such an institution’s failure would be enormous.

Eurex Repo

Eurex Repo GmbH is a multilateral trading facility (MTF) regulated by the Markets in Financial Instruments Directive 2004/39/EC (MiFID) and supervised by the BaFin. It offers an electronic platform for trading Swiss-franc and Euro-denominated repurchase agreements (i.e., repos) among banks and the GC Pooling market,⁵⁶ which has become the European benchmark for standardized secured funding with central clearing.⁵⁷ Eurex Repo offers customers full automation from clearing to settlement.

The underlyings for Euro-denominated repos are standardized baskets for the general collateral (GC) market,⁵⁸ which include the German GC, German Jumbo, and the German KfW/Länder baskets. Trades can also be conducted with Austrian government bonds and European Investment Bank treasury bonds.

German GC Basket includes German government bonds and bonds issued by the Treuhandanstalt, the German privatization agency. Included in the German Jumbo Basket are Jumbo Mortgage bonds (Pfandbriefe) issued by German companies. Finally, the KfW/Länder Basket is based on bonds issued by KfW and German federal states.⁵⁹

Conclusion

Derivative markets for Swiss-franc-denominated products include (1) OTC options, forwards, and swaps, (2) exchange-traded derivatives, and (3) structured products. Used properly, they are cost-effective ways to hedge, enhance yields, speculate, and gain access to products that might not otherwise be accessible. As long as markets are liquid, efficient, and fair, derivatives can quickly transfer unwanted risks. Just as life-saving medicines can be used moderately and wisely, derivatives can too. But derivative overdoses involving huge casino-like gambles are real and can devastate users and others around them.

Before going into a title fight, heavyweight boxing champion Mike Tyson once said, “Everyone has a plan until they get punched in the mouth.” For a nation’s financial system, this punch in the mouth comes when good intentions to let markets flourish are met with destructive and misused derivative activity. The solar-plexus blow comes when customers use them to financial ruin, and banks generate in-house research and derivative products that have no relation to companies’ value creation. In these cases, their purpose is nothing more than to increase bank profits. Extreme uses of derivatives can turn positive-sum games into zero-sum or negative-sum ones.

In the future, Switzerland's competitiveness and profitability will depend on its ability to create innovative, cutting-edge derivatives. Earning a stellar legacy, though, is more nuanced and important. For that, the Swiss financial community must find ways to empower these financial instruments for productive uses and, at the same time, harness their harmful, negative-sum social and economic effects.