What are Bank Derivatives?

M. McGee

Bank derivatives are a financial instrument traded privately between banks in an over-the-counter (OTC) format. These derivatives are typically agreements to buy or sell certain items at a future date. In and of themselves, bank derivatives have no value, as they are simply trade agreements. Even so, derivatives can be a lucrative market, as an agreement to purchase something in the future at an under-market price can potentially make a lot of money. These derivatives are separate from exchange derivatives, which are sold on the open market.

Businessman with a briefcase
Businessman with a briefcase

Derivatives are a complex part of the financial markets. These instruments are contracts that state something will happen at some future time. For example, OneCompany could offer to sell TwoCompany a certain number of shares at a specific price before 12 October. This means that at any time between now and 12 October, OneCompany must offer the shares to TwoCompany. TwoCompany buys the derivative and hopes that OneComapany’s stock will increase in price, thereby making the shares purchased less expensive than the going rate.

Derivatives could be placed on nearly anything that has value and may be set up in a wide number of ways. The valuable item could be anything from a portion of a company to a stack of gold coins, to the US Dollar (USD). When the initial contract is set up, the people involved are betting on the difference in value between now and when the derivative comes due.

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The above information is for derivatives in general, but bank derivatives are more specific. The selling of derivatives takes place in to main formats, exchange and OTC. Exchange trading takes place out in the open on public exchanges. This means that trades are overseen and regulated by the local securities department—in the US, that is the Securities Exchange Commission—, and all of the exchanges are recorded. The OTC market is not directly regulated and takes place almost entirely through banks.

These bank derivatives are often contracts made between different companies. The bank acts as a neutral third party and holds the money for the transaction. While the bank does keep detailed records of the transaction, it typically does not disclose those records unless it is required to. This means the sales are largely unknown outside the involved parties.

One of the main reasons to use OTC bank derivatives is to keep sales from having an impact on the exchange price of the valuable object. When a sale happens in the exchange market, the price of the associated item may go up or down accordingly. When the sale is kept private, the associate item won’t be affected.

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